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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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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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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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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The word "mortgage" is probably one of those most widely misused words that eventually the misnomer will trump its true definition. When people say they are applying for a mortgage, paying a mortgage, refinancing a mortgage, they really mean they are applying for, paying, or refinancing a home loan.

A home loan is a loan. It has its terms: principal, interest rate, number of months to pay, etc. etc. The home loan is evidenced by a Promissory Note. The Note is secured by the borrower’s home. The security document that pledges the home in exchange for the loan is called the mortgage in some states.

The mortgage is given by the borrower to the lender. The borrower doesn’t have a mortgage. The lender has it. The party giving the mortgage, the borrower, is called the mortgagor. The party receiving the mortgage, the lender, is called the mortgagee. The mortgagee (lender) has the mortgage from the mortgagor (borrower). If the borrower defaults on the loan, the mortgagee goes to a court and asks a judge to foreclose the borrower’s home. This is called a judicial foreclosure.

That’s how it works in some states. In other states, the borrower does not give a mortgage to the lender. The borrower signs a Deed of Trust. That makes the borrower the grantor of the trust, and the lender the beneficiary of the trust. There’s a 3rd party trustee for the Deed of Trust. The trustee listens to whoever ends up owning the Note. If the loan servicer tells the trustee to sell the home, the trustee will sell the home. With a Deed of Trust, the trustee doesn’t even have to go to a court to get a judge to approve the foreclosure. They do it by themselves. It’s called a non-judicial foreclosure.

My state uses a Deed of Trust. I’m the grantor. MERS is the beneficiary. Some articles on the web say 34 states in the U.S. use a Deed of Trust either exclusively or primarily, although I count only 21 states in this Mortgage and Deed of Trust State Matrix published by a loan document production company Document Systems, Inc.

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[1] B of A does not give a point estimate. The mid-point between low and high in its estimated range is used.

For my home, Cyberhomes matched the appraisal most closely. Its estimate also happened to be the lowest. It’s possible I just got a low-ball appraisal. The recently published Home Valuation Code of Conduct (HVCC) made it more difficult for the lenders and brokers to influence the appraisal. It also created an extra layer of review by an appraisal management company. The appraisal report did list five comparables with adjustments for various things. If you use these home valuation web sites for an estimate of your home’s value in your net worth tracking, it’s probably prudent to take the lowest estimate, rather than the average from all these sites. Zillow in particular is way off to the high side for my home.

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Before I make the first payment on my new loan, my new lender already sold the loan to another bank. Actually their paired me with that other bank at the time I locked my rate. I expect a letter from this new bank with a new loan number. The whole refinancing process took 40 days from the day I submitted the loan application to the day my old loan was paid off. I’m glad it’s finally done and over with.

In retrospect, I think I entered the value of my home too high on the mortgage application for the automated underwriting system. That triggered the requirement for a full appraisal. Had I given the lowest value necessary for my refi, I might have been able to get my application approved without requiring an appraisal or with only a drive-by appraisal.

A big chunk of time spent in my refinancing process was waiting for the appraisal report. I had wanted to close the refi before I went on vacation. I wasted two weeks and much anxiety on waiting for the appraisal. I may also have been able to save myself a few hundred dollars if I didn’t need an appraisal.

It may be counter-intuitive, but when you do a mortgage application, put down the value of your home as low as necessary. If you only need 80% loan-to-value (LTV) ratio, giving a high value for your home and making your LTV lower than necessary does not help you and it may cost you both time and money. The automated underwriting system does not believe the high value you give it anyway.

If I could do it again, I would also use my own local settlement agent as opposed to the settlement agent selected by the lender. At the time of signing, the lender’s settlement agent sent over a notary to my office. That was convenient, but the notary does not work for the settlement agent. She’s just an outsourced contractor for gathering signatures. As such, she couldn’t answer any question about the settlement process: Will the payoff be by wire or by check? Will it be done on the same day as the funding or on the next day? Nor could she explain the loan documents. She only got the loan documents that same morning.

After she collected the signatures and signed where a notary was required to sign, she sent the whole package off by FedEx to the settlement agent a thousand miles away. If there were any problems or somebody missed a signature somewhere, it would be hard to correct them. In the past, I went to a local office. The person at the signing table was the settlement agent. They were able to answer all the questions and explain the documents. After everything was done, they sent me a CD with all the documents I signed. That made filing so much easier. Now I have a big stack of documents, most of which I have to shred.

Let’s not forget using the lender-picked settlement agent a thousand miles away also caused me the last-minute scramble for the required certified check. I will manage the process better next time.

On the bright side, I caught a dip in mortgage rates. The lender delivered what they promised. The rates are about 0.5% higher now. With no out of pocket cost and no increase in principal balance, only the investment of my time in filling out forms, sending faxes, writing e-mails and making phone calls, I was able to lower my mortgage rate and save about $1,000 a year for many years to come. A 4.5% mortgage is worth the investment of my time and energy. I will be watching for more dips in the future.

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Week 1. Found a good rate. Filled out application.

Week 2. Locked rate. Signed disclosure documents. Faxed supporting documents.

Week 3. Home appraisal. Decided against waiving escrow for a fee.

Week 4. Nothing happened. Appraiser could not produce the appraisal report. Lender agreed to extend rate lock at no charge.

Week 5. Appraisal report finally came. The appraised value was about 20% less than what Zillow shows but it would not affect my ability to refinance. Underwriter approved the loan.

Week 6. Scheduled document signing. The lender’s contracted settlement agent sent over a notary to my office. I signed the documents in front of her. She would then forward the whole thing to the settlement agent by FedEx.

My overall experience with the lender National Mortgage Alliance is positive. The final closing statement matched the rate quote I received initially. There is no bait and switch. The loan advisor is accessible and responsive. My e-mails were replied within hours. When I called, I often got to speak to her, which I couldn’t when I worked with the mortgage broker I used (90% of my calls went to voicemail). I also learned through this mortgage refinance process about the business model of a direct lender. I will write about it in another post in the future.

P.S. It looks like I just dodged a mortgage rate tsunami. The mortgage rate jumped as much as 0.75% in a single day yesterday. From Mr. Mortgage Blog: 5-28 – Potential Consequences of 5.5% Mortgage Rates (via Mish). I’m keeping my fingers crossed that the loan will fund.

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Week 1. Found a good rate. Filled out application.

Week 2. Locked rate. Signed disclosure documents. Faxed supporting documents.

Monday May 4, 2009. An appraiser came and did an appraisal. I didn’t have to do a full appraisal in my last several refinances. Last time the broker paid $100 appraisal waiver fee (cheaper than a real appraisal). Before that, they did a "drive-by appraisal," just verifying the house was standing. This time the lender insisted on a full appraisal. Either the lenders are more cautious than before or it’s a mandate from Fannie Mae. No biggie. It just adds an extra step to the process.

I also had to decide last week whether I want to do the impound aka escrow account for my property tax and homeowner’s insurance. The alternative is to pay an extra fee and have them waive that requirement. Lenders prefer that the borrower pays property tax and homeowner’s insurance into an impound or escrow account. That way they will make sure the tax and insurance bills are paid. It protects their interest. They also earn some float from the money. My loan advisor told me Fannie Mae charges them a fee if the loan does not have an escrow. They are passing that fee down to me.

Most people if given a choice probably will not use impound or escrow account because it unnecessarily complicates paying the tax and insurance bills. But if you have to pay a fee to get rid of annoyance, you have to decide if the fee is worth it. You can try to negotiate away the escrow waiver fee. At the same time, if you are also able to negotiate an additional credit in lieu of the escrow waiver, you are still effectively paying the fee because you give up the additional credit.

From a lost interest point of view, paying a fee to waive the escrow is not a good deal right now. The interest rate is very low. In some states you actually earn a little bit of interest in the escrow account, which to some degree offsets the lost interest. I made this break-even calculator

Impound / Escrow Waiver Fee Break-Even

It shows it will take several years to earn back the fee from the lost interest.

I also learned I will have a good chance to get the escrow waived after the loan is sold. It depends on who ends up servicing the loan. Some servicers will close the escrow account upon request if the loan-to-value ratio is sufficiently low. I decided to take my chance after the loan is sold. I will do the escrow and pocket the escrow waiver fee.

The loan advisor warned me that the money I must bring to the table at closing will be higher if I don’t waive escrow, because they have to collect a few months of tax and insurance as cushion for the escrow account. I’m OK with that because that amount is a cash outflow, not a cost.

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