Making the perfect decision requires a crystal ball. Will the mortgage rate go down in the future? When and by how much? How long are you going to keep this loan? Note I didn’t ask how long you are going to stay in the house, because you can still stay in the house and refinance the loan again if the rate goes down.

The good thing is we have some calculators to help us make this decision. I will use a hypothetical loan as an example. Say I want a $200,000 loan in Missouri with a 30-year fixed rate, I see these choices from a lender’s website:

Kalotay Calculator

First I use the Andrew Kalotay Associates’ Optimum Mortgage Refinancing Calculator. I wrote about this calculator in a previous post. I like this calculator because it takes into consideration the possibility to refinance again if rates goes down in the future.

I enter the no closing cost loan as my current mortgage. This is very important. Forget about the real current mortgage if it has a higher rate. I know at a minimum I can refinance to 4.5% with no cost. Therefore the no cost loan is my baseline.

Then I enter 4.375% with $1,269 closing cost as my proposed new mortgage. The calculator tells me "Not Yet!" which means I shouldn’t pay $1,269 to take the rate down from 4.5% to 4.375%. The calculator also says Not Yet for the other two scenarios.

Neat, huh?

Mortgage Professor Calculator

To double check the calculation, I use Mortgage Professor’s Calculator 3a for refinancing one fixed rate loan to another fixed rate loan. Once again, I enter the no cost loan as my current loan.

Mortgage Professor’s calculator asks more questions. I provide some reasonable answers. For my three alternatives to the no cost loan, it tells me:

Rate	Total Closing Cost	Savings over 10 years	Breakeven Period
4.375%	$1,269	$431	7 years 6 months
4.250%	$2,669	$703	7 years 11 months
4.125%	$4,241	$770	8 years 6 months

Paying a higher closing cost will give me some savings over 10 years, although really small. The breakeven period, i.e. the time I have to keep the loan in order to benefit from the refinance is really long.

For my hypothetical example, both calculators tell me it’s really not worth it to pay the closing cost for a slightly lower rate. When it’s time to evaluate your tradeoff between rate and closing cost, try these two calculators.

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Software picked, likely related articles at The Finance Buff:

• "No Cost" Mortgage Refinance: Stepping Down the Ladder
• Waiting For a No Cost Mortgage Refinance
• Last Train for Mortgage Refinance

My previous two refi’s were done through National Mortgage Alliance (NMA). NMA did the jobs well both times. My last one finished in 2 weeks from application to closing.

So why change? Lower cost for the same rate and term. Is it worth it? I think so. Let me explain how I chose the lender in this post.

It Doesn’t Have to be Local

Right now 90% of the loans end up being sold to Fannie Mae or Freddie Mac. As long as the rate and fees are low, which bank does the loan origination doesn’t matter that much. It certainly doesn’t have to be local.

Small banks like NMA or First IB are just fronts for larger banks, which are in turn fronts for Fannie and Freddie.

A small bank originates the loan and sells the loan to a larger bank after the loan closes. The larger bank keeps the servicing and then sells the loan to Fannie or Freddie. Fannie and Freddie borrow from the global financial market. The government pays Fannie and Freddie for their losses. Everybody is happy! Well maybe not the government and taxpayers, after losing some $200 billion on Fannie and Freddie.

Insist On Pricing Transparency

Many lenders, including some otherwise good credit unions, still don’t quote the total cost online. They will quote a rate but you’ll have to call to get the total cost. That way they can quote different prices to different people. They can quote a low price when you are shopping, then give you a high price when you decide to pull the trigger. Classic bait and switch.

I’m not saying every lender will cheat the customers, but the opportunity is there if pricing isn’t transparent. You will more likely get a better deal if you get transparent pricing.

Rate and Closing Cost Are Equally Important

Rate and closing cost are related. You can get a low rate by paying a high closing cost. Or you can get a low closing cost by paying a high rate. A low rate by itself isn’t the whole picture. Lender A offering a lower rate with a higher closing cost isn’t necessarily giving you a better deal than lender B offering a higher rate with a lower closing cost.

When you compare offers, keep one variable constant. Because rates usually go by 0.125% increments, it’s easier to keep the rate constant and compare the total closing cost. Get two quotes from each lender: one with a higher rate but no or minimal total closing cost, another with a lower rate but a higher total closing cost. You will need these for calculating the rate versus closing cost tradeoff later.

Compare Total Cost Apples to Apples

Rates change every day, often more than once a day. You can’t compare a quote from lender A yesterday to a quote from lender B today or even one quote in the morning to another quote in the afternoon. For this reason, I only consider lenders who update quotes on their website at least daily. If you go to a lender’s site on two different days and the quotes are the same, you are not getting the most current information.

By closing cost, I mean total closing cost. That includes points, origination fee, appraisal, title, settlement, processing, recording, and whatever else they call it,  everything except:

• first month interest
• homeowners insurance
• property tax
• escrow account deposit

Although I have to bring cash to pay for these last four items at closing, they are not really a cost. Everything else should be included in the total closing cost.

Go Shopping

When I shopped for this refi, I also looked at another low cost lender AmeriSave. Like NMA, AmeriSave is an upfront mortgage lender certified by the Mortgage Professor.

I monitored the rate and total closing costs from First IB, NMA, and AmeriSave daily. Every day at around 11:00 am Eastern Time I got a quote from all three lenders. Here’s a chart showing the all-in closing cost for the loan I wanted over five days:

As you see, the cost difference was consistent. First IB was the lowest, AmeriSave a close second, NMA much higher than the other two. Of course for a different loan in a different state at different times the order can be completely different. It’s good to check the rate and total costs for your own loan.

Besides the slightly lower total closing cost, I chose First IB over AmeriSave because I don’t like how AmeriSave tries to make its rates and fees look lower than they really are.

The super low rates on the left hand of AmeriSave’s home page require a very high up front cost. You have to use the quote box on the right. Then the rates and fees they show you require a 800+ credit score. If your credit score isn’t 800 or above, you will have to change the credit score in the quote box on the results page and re-quote. The fees will go up by hundreds of dollars if your credit score is 780, then hundreds more if it’s 760.

I know of no other lender that charges more for a 780 credit score than for a 800 credit score. According to a mortgage banker by the name of MMNJ on FatWallet, the typical credit score cutoffs for the best rate and fees are 700-740. By creating finer pricing tiers, AmeriSave is able to show offers it won’t really give to many customers.

After taking into account the credit score, AmeriSave’s rate and fees are still competitive and way lower than most other places. You just have to wade through the lowball offers and get a realistic quote if your credit score isn’t 800 or above.

What You See Is What You Get?

In addition to low cost, it’s also important to be able to lock in the rate and the total closing cost you see on the website. A good offer you can’t lock is of no use to you.

In this regard, NMA is the best among the three lenders I considered. If you see a good rate at NMA’s website, apply online. If your credit score passes, you can lock the rate on the same day after you pay a $300 deposit.

AmeriSave requires an upfront payment, income documentation, and maybe completing the appraisal before you can lock the rate. When those are done, rates and fees will have changed but you’ve already paid a few hundred dollars.

First IB is somewhere in the middle. I wasn’t offered a chance to lock the rate when I submitted the online application. After I faxed paystubs and W-2, I was allowed to lock the rate but the rate went up. So I waited. I locked the rate a few days later when the rate came down. I didn’t have to pay anything before I locked.

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Software picked, likely related articles at The Finance Buff:

• Signed Mortgage Refinance Documents
• Last Train for Mortgage Refinance
• Mortgage Rates Back to April Lows

Banks

If the prospective lender is a bank, you can try finding it in FDIC’s directory. For example I’m using First Internet Bank of Indiana. I see it in FDIC’s directory. It’s been FDIC insured since 1998. Previously I used National Mortgage Alliance, which is a division of Georgia Banking Company. Georgia Banking Company is also a FDIC-insured bank.

After you find the bank in FDIC’s directory, you can see many links to other data about the bank. The Summary of Deposits link shows you how big the bank is. The latest report shows First Internet Bank of Indiana had $454 million in deposits. Georgia Banking Company had $182 million in deposits. By comparison Bank of America had $914 billion in deposits, some 2,000 to 5,000 times the size of the two small banks I used respectively.

Credit Unions

You can verify a credit union similarly using NCUA’s Find a Credit Union webpage. Fellow blogger indexfundfan used Star One Credit Union. I see it’s been insured by NCUA since 1971 and it has $5 billion in assets.

Mortgage Companies

The lender can be just a mortgage company, not a bank or credit union. These companies report their mortgage activities to Federal Financial Institutions Examination Council (FFIEC) under the Home Mortgage Disclosure Act (HMDA). You can find mortgage companies (and banks and credit unions) in FFIEC’s HMDA disclosure database.

When I shopped my mortgage refinance, I also considered a company called AmeriSave, officially AmeriSave Mortgage Corporation. From the HMDA reports, I see in 2008 it originated 505 conventional purchase loans and 3,100 conventional refinances for 1-4 family units. It’s legit.

Mortgage Brokers

If you are considering a mortgage broker, you can see if they are a member of National Association of Mortgage Brokers (NAMB). NAMB has a find a NAMB broker listing. I’m able to find the mortgage broker I worked with in the past.

Department of Real Estate in your state licenses mortgage brokers. You can verify the broker’s status on your state’s Department of Real Estate website. I can see from my state’s Department of Real Estate website that the broker I used before has been licensed since 1988. There were no disciplinary actions against him.

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Software picked, likely related articles at The Finance Buff:

• Signed Mortgage Refinance Documents
• Last Train for Mortgage Refinance
• Mortgage Rates Back to April Lows

This time, instead of going to my twice favorite National Mortgage Alliance (NMA), I’m using a different bank: First Internet Bank of Indiana ("First IB"). Don’t laugh; it’s a real bank (FDIC cert. # 34607). It just has a name from the dot com era because it was established during the dot com boom in 1998. It still does business primarily through the Internet without a physical branch, just like ING Direct.

The reason for going with First IB is of course its lower fees. For the same rate and term, First IB’s fees are much lower than NMA’s. I heard about First IB from the FatWallet Finance forum. Several people there posted positive experience with First IB.

I just locked my rate. The all-in closing cost comes to about $100. It’s close enough to call it a no cost refi. Even though every time it feels like the rate can’t go any lower, I’m still going with a no cost refi to preserve my option for another round down the road. Who knows, maybe someday the mortgage rate will go down to 2%.

As usual, I will update the progress of this refi as it moves along. They will be under the "refi 2010" tag.

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Software picked, likely related articles at The Finance Buff:

• Cost of Driving One Mile
• "No Cost" Mortgage Refinance: Stepping Down the Ladder
• Waiting For a No Cost Mortgage Refinance

I’ve been following a step-down-the-ladder approach for mortgage refinancing. Whenever I can lower my rate for at least 0.25% with no closing cost (credit from the lender covers closing cost), I would do it because I have nothing to lose. Every time I do it, I save hundreds of dollars a year, every year.

The Fed purchased $1.25 trillion in mortgage-backed securities. The purchase has kept the mortgage rates low. When the life support is withdrawn, the rates won’t necessarily jump up immediately, but I don’t see how the rates will be lower without the support than with the support.

I’m going with the same lender I used last year: National Mortgage Alliance (NMA). I like NMA because their rates and fees are the best I can find for my loan. They also show a transparent trade-off between rates and fees on their website. For example, at the time I’m writing this, NMA shows these for a hypothetical $150k 30-year fixed loan for a home valued at $200k in Missouri:

It makes it very easy to compare against offers from other lenders. You either find the same rate and compare the fees or find a similar fee and compare the rates.

I locked my rate at 4.25% with no point and no closing cost for 15-year fixed. With the lessons I learned from last year, I was able to get the automated underwriting system to waive the appraisal. That will save a lot of time and some money.

The refi is scheduled to close by March 31. If it does, it will be one of the fastest closing I’ve ever had.

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Software picked, likely related articles at The Finance Buff:

• Hopping On Another Refi Train
• Cost of Driving One Mile
• Mortgage Rates Back to April Lows

Andrew Kalotay Associates is a fixed income analytics and debt management advisory services company in New York. They sent me a special report they wrote for Mortgage Bankers Association, the industry trade group.

A Financial Analysis of Consumer Mortgage Decisions, Andrew J. Kalotay and Qi Fu

The 60-page report attempts to answer three common questions in getting a mortgage. Two of which are of interest to me.

1. How many points should you pay on your (fixed rate) mortgage? No point, 1 point, 2 points, or a no-cost loan with negative points?

Most of the calculators on the web, including ones created by The Mortgage Professor, use break-even analysis. They show you how long you will break even between different loans. Then they ask you “how long will you keep the house?” That’s actually the wrong question to ask. The correct question should be “how long will you keep the loan?” because you can refinance if the rate goes down.

The Kalotay and Fu paper takes a different approach. It applies “industrial strength” option pricing model to these loan decisions.

A mortgage loan in the U.S. is basically a callable bond. When a borrower gets a loan, the borrower issues a bond to the lender. The borrower is also free to call the bond at par at any time. The call option embedded in the bond has value. The value of the call option differs depending on the interest rate, interest rate volatility, and the remaining term of the loan.

Comparing different loans means comparing the APR for the loan payments, the upfront cost, and the value of the call option. Kalotay and Fu call it option-adjusted APR or APRPlus.

They created a mortgage points calculator for comparing APRPlus. I got some current quotes for a 30-year fixed rate loan from a lender and I calculated the regular APR and the APRPlus:

The 5% loan is a no-cost loan. There is little upfront cost, but it has the highest rate and the highest APR. The 4.5% loan has a high upfront cost with a low APR. After adjusting for the value of the call option, the option-adjusted APRs for all these loans are practically identical.

Even after adjusting for the value of the call option, I think it still biases toward the loan with a higher upfront cost, because the typical holding period for a 30-year loan is much shorter than 30 years even without refinancing.

2. Should you refinance now?

Kalotay and Fu apply the same option pricing framework to the mortgage refinancing decision. When you refinance to a lower rate, you also reduce the value of the embedded option in the loan. The cost savings from refinancing must be sufficient to cover the loss of the option value. This is the same decision framework corporate treasurers use when they decide when to call their bonds.

Because homeowners can’t easily calculate the value of the call option in their loan, Andrew Kalotay Associates developed a mortgage refinancing calculator for us. You enter the information about your current loan and the refinancing offer. The calculator will calculate a Kalotay Refi Score (the higher the better), together with a recommended action. You will get “Don’t Even Think About It!”, “Not Yet!”, “OK, But Not Optimal”, or “Go For It!”

For example, if someone has a $200k mortgage at 5.25% with 28 years to go, refinancing to a 5.0% loan with $2,000 closing cost will get a “Not Yet!”. Cutting down the closing cost to $1,500 will get a “OK, But Not Optimal”. If the closing cost can be reduced to $950 or less, the calculator will say “Go For It!”

I like these option-aware calculators. The mortgage rates are low once again. Try them and see if you should refinance. I already sent out an e-mail to the loan officer I used last time. When the rate hits my target, they will let me know.

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Software picked, likely related articles at The Finance Buff:

• Mortgage Refinance: Tradeoff Between Rate and Closing Cost
• Hopping On Another Refi Train
• "No Cost" Mortgage Refinance: Stepping Down the Ladder

If you missed the April lows, now you have another chance to start calling for refinance rates. The benchmark rate for 30-year fixed should be 5.0%, no point. For 15-year fixed, it should be 4.5%, no point. Those are the rates I see at the lender I used last time. If your current mortgage rate is higher than the rates for a no-cost refi, refinancing will save you money from day one.

I will start watching the rates. If the rate drops another quarter percent, I will refinance again.

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Software picked, likely related articles at The Finance Buff:

• Waiting For a No Cost Mortgage Refinance
• I’m Refinancing My Mortgage
• I Bonds Rate Guess for Nov. 1, 2006

Study Finds Underwater Borrowers Drowned Themselves with Refinancings

From that WSJ blog post, I read this research paper:

LaCour-Little, Michael, Eric Rosenblatt, and Vincent Yao, 2009. Follow the Money: A Close Look at Recent Southern California Foreclosures

A professor from California State University and two researchers from Fannie Mae studied about 3,600 residential foreclosures in five counties in Southern California in 2006 and 2007. They found the vast majority of homeowners in these foreclosures had negative equity (not a surprise). They then tried to trace the source of the negative equity.

How did they become upside down? Was it because the value of the homes dropped below the original purchase price or was it because of something else? The researchers found that the primary driver for the negative equity was the homeowners’ post-purchase equity extraction through home equity loans, HELOCs, and cash-out refi’s, not the home price declines.

That rings a bell. I posted a story I heard on the radio last year in Refinanced to Foreclosure. A lady called a talk show program saying WaMu foreclosed the family home she owned for 35 years. She loved the home. She raised her kids in it. How did she lose a home she owned for 35 years? The only explanation would be she took her equity out through subsequent borrowing.

If the lady took her equity out already, was the foreclosure a financial loss to her? We don’t know about her specifically, but we can look at the homeowners in the study. The authors of the study wrote:

“Even after these foreclosure events, the unleveraged return on investment for these property owners is very high: roughly 40% over their holding period. If borrowers financed these purchases with 100% financing, of course, the returns on investment are infinite. Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear.”

Now, that’s an inconvenient truth. The foreclosed homeowners made money. Who knew? On average they held their homes for 5-1/2 years. Making 40%, tax free, over 5-1/2 years is quite good, isn’t it?

I have to say these homeowners are smarter than I am. I did several refi’s but I never took any cash out. My home’s value is back to the same as my original purchase price. My rate of return is zero.

Learn this trick from the foreclosed homeowners: when your home goes up in value, follow the high watermark and get your equity out. When your home’s value goes down, demand a loan modification. If that doesn’t work, exercise your put option. That’s how you make money in real estate.

I e-mailed Professor LaCour-Little and asked him if he calculated the average rate of return grouped by the year of the purchase. He said he’d look into it in the next iteration of the paper.

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When you use an escrow account, you pay a few hundred dollars extra every month on top of your regular monthly mortgage payment. The mortgage servicer holds those money until your property tax and homeowners insurance bills come due. Then they use that money to pay the tax and insurance bills.

I was hoping the mortgage servicer would cancel the escrow account after the loan is sold and the servicing is transferred. But they said no. They won’t close it unless I pay them a fee. I will just stick with it.

One reason (not the only reason) people don’t like using an escrow account is that the money for tax and insurance stays with the mortgage servicer before the bills are due. People prefer to keep the money in their own account and earn interest on it. I made an escrow waiver fee breakeven spreadsheet for this purpose.

Are banks required to pay interest on mortgage escrow accounts? Like almost anything in finance, the answer to this naively simple question is very complicated. Way too complicated in my humble opinion. The requirements vary from state to state. Only lawyers are able to figure it out. Here’s a 29-page document that answers this one simple question:

State Interest On Escrow Laws For Residential Mortgage Loans, Prepared for the Mortgage Bankers Association by Buckley Kolar LLP, February 2007

According to the document, if you are in one of these 14 states, banks may be required to pay interest on your escrow account (there are exceptions):

• California
• Connecticut
• Iowa
• Maine
• Maryland
• Massachusetts
• Minnesota
• New Hampshire
• New York
• Oregon
• Rhode Island
• Utah
• Vermont
• Wisconsin

I was surprised to find out that my escrow account pays interest. Ironically the interest rate on my mortgage escrow account is higher than what I can earn in any money market fund right now and for the foreseeable future. I’m not complaining.

The laws must have been made when interest rate was high. That’s understandable because when interest rate was high, people complained most loudly if the banks didn’t pay interest on escrow accounts. The lawmakers never imagined that one day the Fed would cut the short-term interest rate to zero.

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Software picked, likely related articles at The Finance Buff:

• Is an Escrow Waiver Fee Worth It?
• Mortgage Refinance: Closing Process Explained
• Signed Mortgage Refinance Documents

I did the refi through National Mortgage Alliance (NMA), which is a division of a bank Georgia Banking Company (GBC). The name on my loan paperwork was “Georgia Banking Company dba National Mortgage Alliance.” Officially, I borrowed money from GBC. But at the time I locked my rate in April, six weeks before the refi was closed, I already knew that my loan would be sold to another bank right after it closed.

Let’s call this other bank Bank B. When I locked my rate with NMA, NMA also paired my loan with Bank B. The money, for all practical purpose, really came from Bank B. It was only routed through GBC/NMA temporarily. NMA earned the difference between what Bank B offered and what it offered to me.

This business model is actually very similar to that of a mortgage broker, with the exception that NMA’s name showed up on my loan paperwork, whereas a loan through a mortgage broker would have Bank B’s name on the loan paperwork.

I learned that this business model is called correspondent lending. The bank that deals with the borrowers on the front line is called a correspondent lender. They sometimes advertise themselves as a direct lender although they only make a loan if someone else buys it. A bank that provides short-term financing to the correspondent lender is called a warehouse lender. The short-term financing given to the correspondent lender is called a warehouse line. The bank that ultimately takes over the loan is called an investor.

This 30-minute video by Morgan at Blown Mortgage blog explains thoroughly what happens behind the scenes in correspondent lending:

Understanding Flow-based Correspondent Lending

It matched my experience perfectly. If you don’t have 30 minutes, here’s the presentation in PDF. Morgan also wrote an excellent post The Mortgage Broker vs. Mortgage Banker Argument which clears up many myths about mortgage brokers versus direct lenders.

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• Signed Mortgage Refinance Documents
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