Refinancing a house for a lower monthly payment and/or cash-out is almost as common as applying for a new credit card. Saving $100 per month on your mortgage payment seems like worthy reason to rewrite the debt on a home, penny saved, penny earned right? Not necessarily.
Traditional mortgages are written with payback terms applied against an amortization payment schedule, typically figured over a 30 year term.Even shorter fixed term, Adjustable Rate Mortgages (ARM’s), use a 30 year amortization schedule to determine the monthly payment, i.e. a 5-Year ARM’s payment is still figured over a 30 year amortization schedule.
Recently 40 year and 50 year amortized loan products have made their way into the available product section at any of your favorite mortgage peddlers, stretching out the pay-back period and thus reducing required monthly payment amounts.
What doesn’t get disclosed are some of the following facts about amortized loans:
On a 30-Year amortization schedule with an 8% interest rate, the first payment is allocated with ~90% going towards interest and ~10% going towards principle.For every $1000 in payment, $900 towards interest and $100 towards paying off the debt. It’s worse for the 40-50 year loans.
This disparity only improves by .01% to 1% better per month (increasing as the loan ages) and it takes ~21 years before your monthly payment is equally allocated towards interest and principle, then tipping in favor of principle over interest. I don’t know anyone who keeps a mortgage for 21 years anymore…
The real financial transgression occurs when you refinance an amortized loan into another amortized loan, even if you are lowering the interest rate and monthly payment.
Below are abbreviated amortization schedules and loan terms that demonstrate how much one stands to pay for a home using a series of 4 refinances every 5 years that both lower interest rate and payments…
Assumptions:
- $100,000 is the original loan amount for simplicity.
- No cash-out transactions, i.e. only refinancing what is owed on the previous mortgage, (demonstrating a best case scenario).
- No pre-payment penalties are assumed.
- 30-Year Fixed Programs are the consistent term.
- Closing costs factored into the equation = $4000
- Payments rounded to the nearest $1.00
Purchase Loan
- Amount Financed = $100,000
- Interest Rate = 8%
- Payment = $734
60 Months later:
- Total Interest Paid = $39,096
- Total Principle Paid = $4930
- Principle Balance to be refinanced = $95,070
Refinance 1
- Amount Financed = $99,070 (Principle balance + closing costs)
- Interest Rate = 7.5%
- Payment = $692.71
60 Months later:
- Total Interest Paid = $36,230
- Total Principle Paid = $5332
- Principle Balance to be refinanced = $93,737
Refinance 2
- Amount Financed = $97,737 (Principle balance + closing costs)
- Interest Rate = 7.0%
- Payment = $650
60 Months later:
- Total Interest Paid = $33,279
- Total Principle Paid = $5736
- Principle Balance to be refinanced = $92,001
Refinance 3
- Amount Financed = $96,001 (Principle balance + closing costs)
- Interest Rate = 6.5%
- Payment = $607
60 Months later:
- Total Interest Paid = $30,274
- Total Principle Paid = $6133
- Principle Balance to be refinanced = $89,868
Refinance 4
- Amount Financed = $93,868 (Principle balance + closing costs)
- Interest Rate = 6.0%
- Payment = $563
60 Months later:
- Total Interest Paid = $27,247
- Total Principle Paid = $6520
- Principle Balance remaining = $87,347
Recap…
25 years and 4 refinances later.
- Your payment has gone down $171/Month (Yay!)
- Total Monies Paid (Interest + Principle + Closing Costs) = $214,777
- Total Remaining Payments @ 6% = $168,396
Assuming the mortgage was then taken to term:
The $100,000 original loan amount would equate to $383,173 in total expense.
Consider that if the original loan was never refinanced, the total expense would be ~$265,000 and paid off 20 years sooner.
What no Truth in Lending Act will tell you…
In effect you are leasing the home from the bank.
Refinancing an amortized loan with another amortized loan will cost you (under this scenario) 383% of the original mortgage amount.
Assuming your home doesn’t double in value and you sell or you don’t hit the lottery, you will never pay your mortgage off.
The mortgage news waves have been understandably saturated with stories of fraud, predatory lending, the sub-prime fallout, and a slew of other tragic tales about an industry that has molested consumers in the wrongest of ways. It seems like only yesterday that I was being challenged as an ignorant blow-hard who ‘slandered’ the mortgage industry without discretion.
Now it’s the rage.
It’s great to see more mortgage pundits pick up the lens of transparency and challenge the status-quo…
Blown Mortgage
The Mortgage Porter
Americas Most Opinionated Mortgage Broker
Mortgages Undressed
LendingClarity
The Mortgage Reports
Mortgage Fraud Blog
The Mortgage Lender Implode-o-Meter
Patrick.re
…all blog-sites populated by fine authors who are less concerned with being politically correct and more in tune with exposing truth.
I read some of your other posts which were interesting in the past, but I don't understand the reason for this one. I doubt the scenario you present is something that happens often if at all, at least not the way you illustrated. The figures you use leave a lot to be desired.
As an example, why are you using 8% for your initial rate? This is the rate someone may have been paying according to Freddie Mac back in August of 2000, over 7 years ago.
I don't think your $4000 in closing costs are too accurate either on a $100,000 loan unless you are dealing with a subprime shyster.
And what is up with refinancing every 5 years for a half a point drop, each time adding $4000 in closing costs to the loan? Look at how rates have historically changed and you will see opportunities to refinance at a half a point lower or more, often occur a lot sooner than 5 years. In fact, someone getting an 8% 30 yr frm in August 2000, would have had the chance to refinance multiple times over the next several years and each time for a rate a half a point or lower than their current rate. This also could have been done by covering closing costs with a rebate and still having a a reasonable rate reduction to boot.
To sum it up, it looks like the gist of what you wrote was don't refinance into the same time loan you had for the same original term and you used some out of whack numbers and time frames to make the case. You can say this is for illustration purposes only, but I myself prefer to see more current and accurate information when making a point.
Good points Mike...Let me explain:
I used a number of assumptions that were not spelled out, to my fault...although the point of the post was to raise awareness that even though it may seem like it's a good idea to lower your interest rate by .5%, it really may not be...
1) I assumed the initial Purchase Loan was executed by a first time home buyer, at a high LTV (as is typically the case). This would explain the 8% initial rate, and/or the effective rate if any type of PMI was required. Too often I see people who think they got a 6.75% rate period...only to have a PMI factor blow the effective rate far higher than that. Granted if this scenario involved a high credit score deep trade line borrower, prior homeowner, 10%+ down payment, and the such, this may not have been the case.
2) Every 5 years was chosen to demonstrate the average amount of time between refinances for a typical American homeowner. Off the top of my head, I cannot cite the source of this data, but will look it up...The FTC rings a bell. In any case, the average time between refi's is actually closer to 3 years, which makes the negative disparity of the numbers even worse.
3) Unfortunately, $4000 on a $100,000 loan is far more common than people think, even today. Again, my assumptions are considering the status-quo, not a seasoned credit player with 700 FICO scores (although they are far from immune).
4) As has been recently revealed in mainstream media, lenders like CWBC often incentivized their employees to push borrowers into higher cost loan programs, even if they qualified for far better. Granted, you won't see a $4000 line item very often, alas when you add up every dollar on the final HUD, it comes real close.
5) I chose $100k as a baseline so people could extrapolate 'the damages' at higher loan amounts with ease.
6) You can't use some arbitrary historic rate chart and apply it to the status-quo. You are assuming here that this is/was/and remains a Conforming borrower and that they were treated as such at every refinance. (See #3)
7) You are assuming that consumers know what a rebate is, and worse, that the mortgage professional actually explains it to them.
To sum it up, I used an all to common practice of the average mortgage consumer...the ones who will never take a different program than a 30 year fixed, refinance (on average) every 5 years, jump at the chance to lower their interest rate by .5%, ignore the detailed facts and potential economic repercussions that encompass 'rate based' refinancing.
I appreciate the solid comment...
Jeff,
There were a lot of assumptions left out but with a more detailed explanation, your point makes more sense. Personally, I still don't believe you would find many actual refi cases falling into this every five year scenario as you presented. I too have seen mention of how long before loans are paid off such as 80% in 5 years, 90% in 7 years and 99% in 12 years. Supposedly the source is Fannie Mae but I could not find the reference to confirm it. I do know the recent downturn in rates during the past several years skewed the payoff time frame of 3 years that your mentioned, which may be accurate for this time frame.
Realistically I think, way too many borrowers have been flipped even more frequently than every five years using an assortment of loan products to pull off the churn, to their detriment. Somewhat akin to the life insurance agent replacing life policies with something slightly better until they get down to the 1 year renewable term deal as the last resort.
I'm not sure what you meant by I can't use an arbitrary historic rate chart and apply it as the status quo. You make it sound like using actual numbers over a number of years is more distortive that what you did in your example. The facts are during a period covering the past 30 or so years, there would have been opportunities for many to refinance into another loan of the same type and term they currently had and to have come out ahead by doing so. This would of course depend on each individual's own situation as one size does not fit all, but the opportunities have and will continue to be there.
No problem. I am not here to split hairs with you. I just didn't get what the purpose of your post was but I now have a better understanding. Also, I am on your side regarding the lack of transparency and regulations in this business - much of what has led to the current debacle now going on.
BTW, weren't you coming out with a program where consumers could get anonymous real-time wholesale quotes online? Is that still in the works or has it been scrapped?
Hey Mike...Yes there was (IS) a program where consumers can get anonymous wholesale quotes online under development. Unfortunately, the hangup was the (now Previous) technology provider, who was full of promises but empty on delivery. A new provider has been engaged and RateSpeed, as it's called, is under full development. Due to the previous providers debacle, and the inordinate amount of time that was wasted, I've decided to keep its current development rather stealthy. Between you and me, it's < 8 weeks from beta release...shhhh ;)
Thx again for the thought provoking comments...