The Two Biggest Mistakes
Fact: On average, in California, people refinance every 43 months (just slightly over 3 1/2 years) and sell their homes every 80 months (or 6 2/3rd years). Only 3% of borrowers carry their 30 yr. mortgage to term (sources--California Assn of Realtors and California Association of Mortgage Brokers).
Refinances, as a rule, come about to secure a lower interest rate. Naturally, sales occur for a variety of reasons: moving up, downsizing, locking in a profit, divorce, new job, etc. So why do people take out 30 yr. fixed rate mortgages and pay a premium of 0.5%-1.5% to obtain them, if they suspect they'll be refinancing or selling long before that? It's one of the imponderables of the mortgage business. My guess is that for many borrowers getting a 30 yr. fixed rate loan was drummed into their heads by their parents, which was about the only loan program available to their forbears. To a great many people, stability means safety and many of them have heard scare stories about adjustable rate mortgages (ARMs). A considerable number of people don*t understand that adjustable rate mortgages are hybrids. (I have had more than one veteran realtor ask me what a 5/1 is). As such, a hybrid is a combination of fixed/adjustable rate components, that is, one wherein the rate remains FIXED for a specific period of time like 3, 5, 7 or 10 years and only after the specified period of time does the interest rate become ADJUSTABLE. (Incidentally, the 1 in a 5/1 ARM refers to the adjustment period, as in once per year). So, in most instances it makes sense to pay less and obtain a one of these in lieu of a 30 yr. fixed rate especially when one expects to refinance or sell their property well within a particular time frame.
As a result of their misunderstanding of these instruments, most borrowers grossly overpay by choosing the wrong debt instrument and compound their error by repeating it over and over again. About 90% of my business is comprised of people doing the following: they choose a 30 yr. fixed rate mortgage and then opt to refinance as interest rates drop into another 30 yr. fixed rate loan. In instances when rates have dropped considerably, many have refinanced multiple times, some as much 2 and 3 times in as many years. This is great for mortgage bankers and brokers, but seldom in the borrowers* best interest. The reason is that while they may be saving $200, $300, or more dollars per month as compared to what they were paying, they have done nothing to reduce their principal. In most cases they have increased their principal by financing the cost of the new mortgage into the loan. Even though you try to educate them, it's usually futile. They insist upon another 30-yr. fixed rate mortgage. So you accommodate them and give them what they want after all, they*re the ones making the payments and they have to be able to sleep at night and not fear that they are going to be unable to make their monthly nut.
Smart borrowers recognize that it is in their best interests to pay down or pay off their principal balance, not necessarily obtain the lowest rate. For example, with a 30 yr. fixed rate mortgage of $500,000 @ 5.375%, the payback is $1,007,946 of which $507,946 is interest. In this example the total interest costs more than equal the loan amount which effectively doubles the cost of the home over 30 years. Most 30 year loans are heavily front-loaded and most of what a borrower pays up front is the interest. In the first year of a 30 year mortgage only $160/ per $1000 paid goes toward principal reduction. By year 5, a borrower has paid one-quarter of all the interest due ($129,519) even though he is only 16% of the way through the loan. By year 10 about one-third of one*s payment is going toward principal, though by now the borrower has paid nearly 50% (or $247,209) of total interest due ($507,946). It takes 17.5 years to achieve parity on interest/principal payment. Then, when homeowners sell or refinance, they typically get another 30 yr. mortgage and perpetuate the mistake all over again. Is it any wonder that very few borrowers ever retire their 30 yr. mortgage?
Some people compound the mistake by taking out interest only mortgages. If you want to maximize your leverage, this is fine in a rising real estate market, but only if you know what you're doing. In a declining one, it is a recipe for disaster because borrowers have not reduced their principal one iota which means that they now have less equity in their property than when they first purchased it. And, as many sadder but wiser borrowers have discovered, they cannot refinance because of their greatly diminished equity (or none at all in cases where they are upside down in their mortgages).
With a conventional amortizing mortgage (one with equal monthly payments over the life of the loan) the interest on the outstanding mortgage balance (principal) is paid first and whatever is left over is credited toward principal reduction. By reversing things and paying the principal down first and having the remainder of the payment applied to the interest accrual seems like it wouldn't make that much of a difference, but in actuality the difference is huge. Because the principal is reduced from day one, less interest is earned on the outstanding loan balance and it effectively negates much of the effect of compound interest and pays off a 30 year loan in about 16.4 years. One unique program that allows this is called the HomeOwnership Accelerator. There is a 5-minute movie at:
http://www.homeownershipaccelerator.net that explains this program. I also have several other ways of mitigating some of these common mistakes when refinancing which I'd be happy to discuss with you by calling me at (760) 726-4600.
In case you were wondering about what the biggest mistake borrowers make.... it's that they shop for an interest rate rather than shopping for a mortgage broker, but that's a whole other story.
In case you were wondering.... What's the biggest mistake borrowers make - it's that they shop for an interest rate rather than shopping for a mortgage broker!
There's no difference between the $100 bill you borrow from a mortgage banker or through a broker: The product is the SAME. As loan originators, we all have access to the SAME programs, the SAME lenders and the SAME rates, with one notable exception---mortgage bankers have only their firm’s limited number of programs. There is only one Fannie Mae and one Freddie Mac and I have them both, as do other loan originators. Since the wholesale rates are essentially the SAME (give or take an 1/8 of a point, which equals $7 per month per $100,000 borrowed), THE VARIATION IN RATES TO THE BORROWER IS SOLELY DUE TO WHAT THE BANKER OR BROKER IS LOOKING TO MAKE ON YOUR LOAN. It's important to grasp this distinction. Just as the horse goes in front of the cart rather than the other way around, so too, the broker determines the rate and THUS IT PAYS TO SHOP FOR A BROKER, NOT FOR AN INTEREST RATE.
Then why do most brokers try to sell mortgage rates rather than expertise and service? BECAUSE IT'S EASIER TO QUOTE A NUMBER THAN TO EDUCATE A BORROWER. WHEN A CUSTOMER IS UNABLE TO DETERMINE HOW A PRODUCT OR SERVICE IS BETTER OR WORSE OR DIFFERENT FROM A COMPETITOR'S A CONFIDENCE GAP OCCURS AND THE CUSTOMER WILL NECESSARILY DEFAULT TO PRICE.
Rate shopping does take time, though. But, even if you have a lot of free time, it's futile because in Southern California alone, there are 254 lenders and the rates change daily. Even if you managed to call all of them in one day you wouldn't necessarily get the lowest rate. The reason is that the lender with today's best rate may not have the best rate tomorrow.
What's more, unless the rate is locked that day, the rate you're quoted is for today only and by the time your rate is locked or your loan docs are in place what you get may be very different from what you were quoted. This is precisely what happened in late June of 2003 wherein the space of 1-week's time rates moved up one full percent! This is another reason that the flyers you may receive in the mail quoting rates are irrelevant because by the time it hits your mail box it's as out of date as last week's newspaper.
When you shop for a rate brokers are very much aware of what you're doing and IF YOU SHOP LONG ENOUGH, YOU'LL PROBABLY END UP WITH THE BIGGEST LIAR. "Bait & Switch" bankers and brokers think that if they offer the lowest rate, you'll do the deal with them. And many of you do. Naturally, the problem arises when you find that they can't deliver as promised. They'll cite a myriad of reasons as to why your loan is "different" from the norm, e.g., your FICO score is too low or your loan to value (LTV) or debt to income (DTI) ratios are too high, while trying to ”up sell” you into something else. By this point you've probably paid for the appraisal and you just want to be done with the whole mess. You certainly don't want to start the process anew with possibly another "liar", so you reluctantly finish the loan with them.
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