Refinancing Lessons & the $712 Question

Most of you are probably asking yourself, "What is a refinance?" If you know the answer to that question then you're probably saying, "Why do I care?" Valid point, most of us millennials don't have a house, and are a long ways from thinking about refinancing. But, the principles I've learned through this refinance could save you thousands when dealing with any finance company, whether you're financing a car, house, boat, etc.

Let's clarify something first, finance simply means to provide funding for something. If you give someone $20 to go buy a case of beer then you are financing (funding) the beer. So when you hear someone say “the finance company” or “I received financing” they are talking about the company funding their purchase or obtaining the funding, respectively.

Now, let me start by giving you a little background. I purchased my house in February 2014 with a Federal Housing Administration (FHA) loan, which requires 3.5% down. I have been aggressively paying down the house so I can refinance. Refinancing is basically obtaining financing for something you have already received financing for. Why would anyone want to go through the financing process again? Because it allows the borrower, me in this story, the chance to get a new interest rate and loan balance.

I purchased my house for $189,900 with $3,441 down, which was more like $8,800 after insurance and fees. I must finance (borrow) $186,459 ($189,900 - $3,441 down payment). Since the interest rates are at historic lows, I decided to do a 30 year fixed rate mortgage at 4.25%. That makes my monthly principle and interest payment $917. The principle and interest payment is the monthly payment required to cover the interest on the loan and pay down the principle in the agreed upon time frame, in this case 30 years or 360 months.

However, a common mistake most first time home-buyers don’t consider is the taxes, insurance and private mortgage insurance (PMI). So at first glance you think, “$917 monthly payment? I can afford that!” But let’s add the other three components.

According to the U.S. Census Bureau, property taxes range from 8.79% (New Jersey) to 0.25% (Louisiana), varying by city. My taxes were ~3% equating to $5,600 a year or $467/month.

Insurance will also vary with each state, the US average for 2015 is $952/year or $79/month, according to ValuePenguin. My insurance was $1,535 a year or $128/month due to the risk of hurricanes and tropical storms.

The last component is PMI. PMI is essentially a hedge for the financing company in the event you default and/or walk away from the mortgage and the house. If you put down less than 20% of the purchase price then you must pay PMI. The less money you put down at closing the more PMI you will pay. The financing company, usually a bank, looks at it this way; if you have more money, or skin in the game, then you’re less likely to walk away from the property. According to Bankrate.com, the PMI can range from 0.30-1.15%. My PMI was $2,450 a year or $205/month.

All those components added together, principle, interest, taxes, insurance and PMI, gives you a monthly mortgage payment of $1,683 for my house, a figure almost twice the size of the original principle and interest payment. There are also other various fees like Home Owners Association (HOA) dues that you must budget for (mine are $565/year).

Of the components that we just discussed that make up your monthly mortgage payment, you can reduce three of them by refinancing; the principle, interest, and the PMI.

So, back to why I chose to refinance. As I said I received an FHA loan, which requires 3.5% down, which is all I really cared about; having the lowest amount of my own money in the deal. Unfortunately, with an FHA loan, the PMI never goes away. I want to emphasize this; at the time of this writing the PMI on an FHA loan never goes away.

As I said it didn’t matter to me at the time. Housing prices were increasing at 10% a year for the past several years so I figured I would sell it within a few years and not worry about the PMI. Then I did something that we all do from time to time…I changed my mind.

If you have asked me about stocks you know I have always been a big fan of Warren Buffet and his philosophy on the stock market. Then it hit me; why don’t I apply Buffet’s stock market philosophy to real estate. I won’t go into all the details why I had this epiphany but nonetheless I decided I would never sell any piece of real estate I owned, which created a dilemma…I had to pay PMI for the life of the loan, a $205/month bill I didn’t want to pay for 360 months ($73,800).

My option, as you might have guessed, was to refinance to a conventional loan. Again, I can only effect three components of my mortgage payment by refinancing; principle, interest and PMI. So I began the analysis on whether I could reduce the principle and interest payment, along with the PMI, to make the refinance really worth my while.

As I mentioned before, the housing market in Houston, TX is exploding with growth, causing prices to increase on average 10% a year over the past several years. It is growing so much that from the time when I purchased my home to the time I had it appraised (bank requires an appraisal before they lend you money) which was about one month, my house increased in value to $193,000, making me $3,100.

I figured I would be clever and make extra payments to my loan balance while the housing prices increased. This would allow me to get rid of PMI because my loan-to-value (LTV) would be less than 80%. Remember, PMI is only on a conventional mortgage when you have over 80% LTV, and the only way to decrease your LTV is to increase the value of your home or decrease the loan amount.

Let’s return to my situation;

• I purchased a home for $189,900.
• I put 3.5% down (~$8,800 after closing costs) and have an $186,459 mortgage.
• I own a $193,000 property which makes my LTV 96.6% ($186,459/$193,000).

To rid myself of the PMI I paid down the loan balance over the next year to $168,000 while interest rates continued to fall below 4%. Everything was going according to plan. The last piece, my house would need to appraise at at least $210,000.

By refinancing with the house at $210,000 my LTV would be 80% ($168,000/$210,000). Which would make my monthly mortgage payment decrease to $1,357 ($790 + $467 + $100) instead of the original $1,683, a savings of $326/month or $117,360 over the life of the loan. The $326 savings is the combination of the removal of PMI, because the LTV is less than 80%, and the reduction in principle and interest payment. The principle and interest payment is lower because the new mortgage is calculated based on the remaining balance of $168,000, the new home value and the current interest rate (3.875%). The refinance is a completely new mortgage and can have completely different terms as the old loan, depending on what you want (FHA vs conventional, etc.).

Unfortunately the example above is how the refinance was supposed to go in an ideal world, but we all know that b@stard Murphy likes to drop in every now and then.

Let’s look at what went wrong, even though it might be a shorter list to look at what went right.

• The appraisal for the new home value was lower than expected ($190,000), causing me to either come to closing with a wad of cash or pay PMI.
• The property taxes were paid late, a screw up by the mortgage company, delaying closing on the refinance and subsequently added a host of fees.
• After the property taxes were paid, they were erroneously paid again, causing me to have to bring more money to closing.
• At closing the PMI was actually higher than the loan officer and I had discussed.

So, what did I do about each incident?

• When the appraisal came in low I wrote a letter to the mortgage company with a few comparables (houses that were similar to mine) to justify why I think the appraisal should have come in higher. Since appraising was what he was paid to do, he didn't take much advice from a 24 year-old kid. Side note: Neighborhoods where the developer is still building houses have a lot less comparables, skewing the actual value of your home.

• At closing the PMI was higher than the Good Faith Estimate (GFE) issued by my finance company. I pointed this out to the title company representative and we called the loan officer. She agreed it was higher than the original estimate because the appraisal was low. PMI was only higher by about $20/month and I had the option to rid the PMI after two years, so I agreed and continued to sign the new mortgage.

• I was told by the loan officer to let the mortgage company pay the taxes for 2014, instead of paying them myself at closing. When the property taxes were paid late by about 35-40 days, I became frustrated with both the mortgage company for paying the taxes late and the refinance loan officer for misleading me. Every day the taxes were late was another day I had to pay more money to keep my 3.875% interest rate locked, they call it a rate lock fee. I eventually paid them myself to be able to continue with the refinance.

After the taxes were paid, I explained how disappointed I was with both the current mortgage company and the refinance company. They had caused me ~$1,500 in rate lock fees, and a lot of my time spent on long phone conversations to straighten everything out. The refinance company had misguided me about letting the current mortgage holder pay the taxes, and I expressed this to the loan officer and her boss.

There seemed to be nothing the refinance company was going to do to make it right. They knew they had me. I had already paid the $400 for a new appraisal, interest rates seemed to be rising and I was just a few days from being able to close and put everything behind me.

So I agreed to close, although I was upset I wanted to be done with this fiasco. Then there was light at the end of the tunnel. I received an email that the loan officers’ boss had agreed to write me a check for $712 at closing!

After everything was said and done I still came out of the refinance ahead, although not as far ahead as I would have liked. There are three specific things from this story that everyone should implement in any transaction;

• Have some reserves for when things go wrong. When someone shows you a projection of this stock or how much money you could make on purchasing a rental, always ask, "What can go wrong? Where are the hidden fees?" Inevitably things will go wrong and when things go wrong they cost money. In an ideal world we can believe the projections and forecasts but be wary of relying solely on these figures. Have some cash reserves to help cushion any unexpected expenses.

• Always have an exit strategy. When things don't go as expected, from the paperwork to unanticipated life incidents, have a backup plan. Have at least one, if not two exit strategies, or ways to get out of your current situation unscathed. I had no backup plan. I spent $400 on the appraisal before I was evening thinking about what to do if the appraisal came in low.

• Don’t be too intimidated to ask questions. I could have easily went through the refinance without asking why I was being punished for something that wasn’t my fault. I knew, as well as they did, my best option was to agree to the current terms. But, I didn’t care. I had to ask the question and I received a $712 check for doing so. I received the check not because it was fair but because I spoke up. Ask questions if you don’t understand something, especially if it involves something as important as a mortgage. Don’t be intimidated by people who you think know more than you.