The mortgage rates dropped again. I’m refinancing my mortgage again. It’s amazing it hasn’t been even a year since I did it last time.
The rates were low last year because of the anticipation for QE2. Once QE2 started, rates went up. Now rates are low again. Why? I don’t know. Maybe the market is expecting a QE3.
This time, instead of following my usual Stepping Down the Ladder script, I’m refinancing my mortgage to an ARM with a cash out. Before you call me crazy for choosing an ARM when rates are lower than ever, bear with me and read to the end.
Stepping Down the Ladder
Stepping Down the Ladder means refinancing to a fixed rate slightly above the market rate, with enough credit from the lender to cover the closing cost. Rinse and repeat every time the rates go lower again.
It’s a no-lose proposition. You start benefiting from the lower rate on day one. As the rates go lower, you keep locking in to a lower rate, and never pay any closing costs. Repeat this process until the rates reach the bottom. Because the rate is fixed, your rate will stay at the bottom.
10-Year and 15-Year Fixed Rate Mortgages
When I looked at refinancing this time, I started with the same method. Because I have a 15-year fixed rate mortgage now, I looked at 15-year fixed and 10-year fixed options.
If I go with another 15-year fixed, the best rate I can get is 3.625% with no closing cost. It’s barely worthwhile because my current rate is 3.75%. If I go with a 10-year fixed, I can get 3.25% with no closing cost.
Between these two options, I would choose the 10-year fixed. I’ve had a 15-year fixed mortgage for a few years now. I’d like to pay it off in 10 years.
5-Year Adjustable Rate Mortgage (ARM)
I usually don’t look at ARMs at all, because the whole idea of Stepping Down the Ladder is about locking in the lowest rate for the life of the loan. But since I was considering a 10-year fixed, I also looked at ARMs.
A 5/1 ARM has a fixed rate for the first five years. The rate starts adjusting annually after five years. If I’m going to pay off in 10 years, by the sixth year the remaining balance will be small enough that I can pay off if I want to. If I don’t like the rate at that time, I will just pay it off. Meanwhile I will have saved quite a bit of interest in the first five years.
If I go with a 5/1 ARM, I can get 2.75% with no closing cost.
Cash Out Refi
A cash-out refi means borrowing more than the current loan balance. Usually you will pay a higher rate and/or higher fees if you refinance with a cash-out. However, if your loan-to-value ratio (LTV) is low enough, there is a ceiling you can go to without incurring a penalty for cash-out.
Why take cash out? Because the lender credit is related to the loan amount. Within certain limits, the higher the loan amount, the higher the lender credit. When the lender credit is high enough, it will be able to bump the rate down a notch and still make it a no closing cost loan.
For example, suppose the lender credit for a $100k loan is $1,000 at 2.625% and the total closing cost is $2,000. It means the net closing cost is $1,000 for the 2.625% rate. To make it no cost you will have to go to 2.75%. However, if you increase the loan amount to $200k, the lender credit will be $2,000, enough to cover the closing cost. Then the $200k loan will be no cost at 2.625%.
If I increase the loan amount to the maximum allowed, I can get a 5/1 ARM at 2.625% with a net $900 paid to me at closing in addition to the cash-out. I grabbed this deal.
I’m using the same lender I used last time: First Internet Bank of Indiana ("FirstIB"). For the loan I want, FirstIB offers the best deal among a short list of lenders I looked at: PenFed, National Mortgage Alliance, and AmeriSave.
Won’t borrowing more increase the total interest paid? Yes, if you only pay the minimum. Because the loan has no prepayment penalty, you can pay the cash-out right back in the first month. The only effect of a higher loan amount will be a higher required monthly payment amount. Since I’m going to follow a 10-year payoff schedule and the 5/1 ARM uses 30-year amortization, the higher required monthly payment is still lower than what I’m going to pay anyway.
For example, to pay off $100k in 10 years at 3.25%, I will have to pay $977 per month. The required monthly payment on a $200k 5/1 ARM at 2.625% with a 30-year amortization is $803. If I borrow $200k, pay back $100k immediately and keep paying $977 a month, the remaining $100k will still be paid off in 10 years.
Borrow More to Invest?
I thought about keeping the cash-out and investing it. After all, it’s hard to see how I can’t earn more than 2.625% a year from my investments. A five-year CD from Melrose Credit Union pays 2.90% a year. If I only pay the required minimum monthly payment and put the cash-out and the extra principal payments in a CD, as long as the CD rate is higher, I will come out ahead. The tax on the CD interest and the tax deduction on the mortgage interest will be a wash.
If I put the extra money in a globally diversified portfolio of stocks and bonds, the return has to be higher — if I don’t believe that I should just liquidate everything, pay off my mortgage, and put the rest all in CDs. Everybody who is carrying a mortgage and investing at the same time is betting the investments will earn more, or else they wouldn’t invest before the loan is paid off.
But expected returns are just that — expected. You can bet and expect all you want. The actual returns may come higher or lower than your expectation.
Although the thought of making money with other people’s money is appealing, I’m not yet that comfortable with it. I may still do the CD but that’s about it. I don’t want to take more risk with this money.
Rates Have Nowhere to Go But Up?
You may think rates have nowhere to go but up and that it’s shortsighted to get an ARM now when rates are the lowest. You may think five years from now interest rates will be much higher.
I thought the same every time I refinanced in the last ten years but rates keep coming down, reaching one historical low after another. I honestly thought it was the last chance to refinance in March 2010. That was two refinances ago.
The market has defied all predictions of higher rates. I will stop saying this will be my last refinance. It won’t surprise me if rates go either way: substantially higher or substantially lower. If rates go down again, I will refinance again with an ARM and extend my 5-year fixed rate period.
When you are within 10 years to paying off your mortgage, refinancing to an ARM can save you money compared to a 10-year fixed rate mortgage. The rate is lower. So are the closing costs (for example PenFed charges a 1% origination fee on all fixed rate mortgages, but not on ARMs).
Taking a cash out and paying it right back will lower the closing costs. You may even get paid for doing the refinance. If you are going to pay off in 10 years anyway, it’s free money.