The Best Way to Refinance a Small Mortgage

A reader asked me about refinancing a mortgage. I gave him my usual spiel about getting a no cost refinance, stepping down the ladder, etc. I also gave him the short list of lenders I shop from: First IB, NMA, and AmeriSave.

He came back to me saying he couldn’t get a no cost refi from any of them because the balance on his current mortgage is too small.

To get a decent rate at around 4% for 30-year fixed, he’ll have to pay $1,500 to $2,000 in closing cost. It just doesn’t make much sense to pay that much to refinance a small mortgage. So what is the best way to refinance a small mortgage?

How Small Is Small?

Of course it’s all relative, but I would say a mortgage balance under $100,000 is small.

Much of the closing cost is fixed regardless of the balance. Appraisal costs a few hundred dollars whether your mortgage balance is $400k or $100k. Escrow agent charges a few hundred dollars regardless. The cost of title insurance has something to do with the mortgage balance but it’s not completely linear (at least not linear everywhere). I picked a random zip code and got quotes from Entitle Direct. On a $400k mortgage, title insurance costs $357. On a $100k mortgage, it still costs $228.

On the other hand, the lender credit you get from paying a slightly higher interest rate is a percentage of the loan size. A small mortgage simply can’t get a large enough lender credit to offset the largely fixed closing cost, unless the rate is so high that it gets close to the current rate.

Does it mean that once your mortgage balance gets below $100k you are pretty much stuck? Not necessarily. You have to go a little off the beaten path.

Solution #1: Cash-Out Refi

I used a cash-out refi on my own mortgage refinance. It requires a low loan-to-value (LTV) ratio. The mortgage balance is small but the value of the home isn’t. The lender I used offered cash-out refi at maximum 60% LTV without a rate penalty.

If you do a cash-out refi to increase the size of the loan to 60% LTV, when you multiply the size of the new loan by the percentage for the lender credit, the resulting dollars may be able to cover the relatively fixed closing cost and still make it a no-cost refi.

After the refi closes, you pay the cash-out back against principal.

Solution #2: Home Equity Loan

Many banks will pay closing costs on a home equity loan. While a Home Equity Line of Credit (HELOC) typically carries a variable interest rate, a Home Equity Loan (HEL) can have a fixed rate. After you use the Home Equity Loan to pay off your current mortgage, the Home Equity Loan works pretty much just like a mortgage.

A Home Equity Loan typically has shorter terms. You don’t get a 30-year term but you can get a 10-year or 15-year fixed rate Home Equity Loan. For a small loan size, a 10-year or 15-year fixed rate Home Equity Loan compares favorably to a 10-year or 15-year mortgage because you won’t have to pay the $1,500-to-$2,000 closing cost.

Right now Pentagon Federal Credit Union (PenFed) offers a home equity loan for owner-occupied homes at maximum 80% LTV at these rates: 2.99% for 5-year, 3.99% for 10-year, 4.49% for 15-year. PenFed will pay all closing costs on a home equity loan. It only requires that you keep the loan for at least two years. Otherwise you will have to reimburse them for the closing costs.

If someone just wants to get their mortgage rate down to under 4%, the 3.99% rate for 10 years looks pretty good. The required monthly payment will be higher because the loan will be paid off in 10 years, but for a small loan size, it’s not too bad.

Solution #3: Adjustable Rate Mortgage

Some banks will pay closing costs for an adjustable rate mortgage (ARM) but they won’t for a fixed rate mortgage. You can save money if you refinance to an ARM.

An ARM carries some interest rate risk, but when your mortgage balance is small, you are probably close to paying it off anyway. The ARM will have a fixed rate for the first few years (typically five years). Within those years, you rate is guaranteed. When the rate starts adjusting, because of the adjustment cap, it won’t go crazy either even if it adjusts higher.

Once again, Pentagon Federal Credit Union (PenFed) offers a great product for this. Its 5/5 ARM carries a fixed rate for the first five years. Then the rate adjusts every five years, with the first adjustment capped at no more than 2% higher than the initial rate. The next adjustment is capped at no mare than 2% higher than the previous rate, with a lifetime cap of no more than 5% higher than the initial fixed rate.

The adjustment caps are referred to as “2/2/5″ which means no more than 2% higher at the first adjustment, no more than 2% higher on each subsequent adjustment, and no more than 5% higher than the initial rate at any time.

This is preferable to the typical 5/1 ARM, which adjusts the rate every year instead of every five years after the first five years. My 5/1 ARM adjusts with “5/2/5″ which means the rate can jump by 5% at the very first adjustment.

Right now the rate on PenFed’s 5/5 ARM is 3.00% for the first five years. With it capped at 5.00% for years 6-10, you have an average rate below 4% for 10 years in the worst case. The blended average rate for 10 years is lower than 4% because your balance is higher in the first 5 years at 3% than your balance in years 6-10 at 5% in the worse case.

PenFed will also pay all closing costs on their 5/5 ARM unless you are refinancing an existing PenFed mortgage. It doesn’t even require a two-year holding period like it does on the home equity loan.

The 5/5 ARM is more flexible than the 10-year home equity loan. First, your required monthly payment is lower because the 5/5 ARM uses a 30-year amortization schedule. Second, the rate for years 6-10 may be lower than the capped rate at 5%. If rate after 10 years is still low, you can keep the loan. If it gets high, you just pay it off. Since the loan size is already small to start with, it will be even smaller after 10 years.

Although this post may sound like a stealth advertisement for PenFed, it isn’t. I wish PenFed would pay me for saying good things about its products but it doesn’t.

Everybody can join PenFed by making a one-time $15-20 donation to one of its supported charities. Select “None of the above” on the online membership form. It’s a great credit union for CDs and loans.

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  1. KD says

    I am one of those with a really small mortgage. The balance left is less than 31K. After thinking it through, it is more of a cash flow problem for me. I can pay it off but then I would have no emergency funds. I tried putting together a plan of using may be credit card with 0% APR for 12 months on purchases etc to create a buffer. But then in absolute dollar terms and unknown risks, it was not worth it. I decided to continue with my early payments without complicating the situation. I will end up paying about 4 months of interest more than what I would like to pay. But it is fair price for the option of going back to regular schedule if something unexpected comes up.

  2. MoneyCone says

    Another satisfied PenFed customer! Though my mortgage is no longer with them, I had a very positive experience with PenFed.

    With FirstIB, it was nothing short of frustrating. Extreme incompetence to say the least.

  3. Denver Todd says

    Keep in miind that with #1, your payments will be based on the higher loan amount, once you factor in the cash back. So even if you apply that cash back to the loan, your payment amount will have increased. So, what’s the benefit, even if the interest rate dropped?

  4. Harry Sit says

    @Denver Todd – The benefit? Interest paid in dollars, both in the current year and over the life of the loan. At a lower rate, you will pay less interest each year. At a higher monthly payment, more of your payment goes to principal, which further reduces the interest you pay. It’s similar to refinancing a 30-year mortgage into a 15-year. You save a bundle each year and over the life of the loan.

  5. Denver Todd says

    TFB, I understand how a lower interest rate leads to lower total interest over the life of the loan, but choosing option #1 would also lead to higher monthly payments. I currently pay $750 P&I on my 150k mortgage. I would rather choose that amount than $1250 in order to get a lower interest rate, even though the outstanding debt would remain the same after paying the cash-back toward the principal. The point I was trying to make was that there is a tradeoff: higher monthly payment for a lower interest rate.

    On another note, I have often wondered how much money I will end up saving on my mortgage, having refinanced four times since 2001. My payments are lower and locked, but the tradeoff is that I have another 30 years to pay, instead of 20. On the other hand, there are other benefits I have gained by refinancing: I got rid of PMI, and I got out of an ARM.

  6. Harry Sit says

    @Denver Todd – When you refinance to a term longer than what you have left on your previous mortgage, you are supposed to pay a little more than the required monthly payment on your new loan (but still less than or equal to your old monthly payment), in order to benefit from the lower rate. Otherwise although your monthly payment is lower, you are stretching the loan longer and you end up paying more interest over the life of the loan. See my previous post Mortgage Refinance and Resetting the Clock.

    In order to use solution #1 (small balance on a home valued much higher), you are often at the tail end of your mortgage. Say you owe $100k at 5% with 10 years to go, the monthly payment would be $1,061. If you do a cash-out to $220k and refinance to a 30-year fixed at 4%, the required monthly payment would be $1,050, which isn’t higher than before. If you pay back $120k immediately and you keep paying the old $1,061 a month, the mortgage will be paid off sooner than 10 years.

    If your monthly cashflow allows it, do the $220k cash-out refinance to a 10-year fixed at 3.25%. The monthly payment jumps to $2,150 even after you pay back $120k. This is the scenario you described. Some banks will allow you to do a recast for a small one-time fee. That’ll get your monthly payment back down.

  7. alanb says

    Wells Fargo offered us a no closing cost refinance on the fixed rate 15 year mortgage they already held. The rate was about 1/8% above market rates at the time, but there was no other fee or charge. The paperwork was done at home, signatures notarized at our bank, and mailed to WF. We owed about $56000, refinanced to another 15 year loan, which lowered the monthly payment by about $1000. We continue to make the same monthly payment as before, applying the excess to principal.

    With the extra principal payments, the loan will be paid off at the same time the old one would have been, but we save $1000 in interest over that time and we have the option of paying less per month should the need arise.

  8. Nony Mas says

    Nice article. What would you recommend in this scenario for a new home purchase? Purchase price– $500K with $400K down, only $100K loan?

    Thanks, love your site

  9. Harry Sit says

    @Nony Mas – I would do a variation of #1 and try to get a 15-year fixed at 3.25% or so. Figure out how much you need to borrow to make it no-cost. Then pay the additional down payment toward principal after you close. The monthly payment will be a little higher than a $100k loan but it will still be manageable. If you really want a low monthly payment, you can try asking for a recast as I mentioned in comment #6.

  10. phototristan says

    This is an interesting and informative article.

    But the 2/2/5 ARM scares me because after the 3rd tier, they are likely to raise the rate 5%! And, you may be totally stuck paying that because by then, you will owe a small amount on the mortgage such that no bank will want to bother to refinance you at that point. If you don’t have the cash to pay it off, you will be stuck with no other choice than paying upwards of 8% (by todays rate calculations), no no way to get out of the loan.

    Is this thinking correct?

  11. Harry Sit says

    @phototristan – You should calculate the projected loan balance. A 8% rate sounds high by today’s standard but it’s not that much if the loan balance is only $10k. Remember we are talking about a small mortgage (< $100k) to begin with. So let's say it's the worse case: 3% in years 1-5, 5% in years 6-10, 7% in years 11-15, 8% in years 16 and beyond. What's the balance in year 16? Will you still own this home at that time?

    It is a risk if you are not going to pay more than the required monthly payment and you are planning to own this home for another 15 years or more. If that's the case, you should pay more than the required monthly payment and pay it off in 15 years (ideally within 10 years so you won't even have to worry about a 7% rate).

  12. Joan Bolton says

    I currently financed with GMAC Mortgage. Recently they called and told me that I would have to pay 600.00 per month on my 2nd mortgage instead of the minimum. I already have a First Mortgage that i pay 865.00 on. The balance of the mortgages are 1st – 42,000 2nd – 25,500. Is there any company that would refinance that back into one loan? I have 2 children in college and it.s really hard. I am also working out of state and having to rent an apartment. Any advice would be appreciated!

    Thank you!!!!
    Joan Bolton

  13. HMC says

    Hello Harry,

    I currently owe $43,000 on my home with 12 years remaining on my mortgage at a fixed rate of 6.5%. Because interest rates are extremely low I’m considering refinancing. I have excellent credit and good equity in my home. I have a great, long standing relationship with my bank who offered me a $50, 000 mortgage at a 2.75 % fixed rate, 15 year loan to refinance. The closing cost to do this is $2,200. Other pre-paid fees total $4,500 for a total of $6,700. After all is said and done, they said I would receive $2,000 at settlement.

    Is this worth it and is refinancing right for me. I would pay $250 per month less on my mortgage than I am currently paying. Should I borrow less than $50,000 and not receive the $2,000 at settlement or take the $2,000 and pay it towards the principal?

    It just seems that staying at a rate of 6.5% with the rates being so low is foolish. I would appreciate your quick response as I am scheduled to go to settlement in a few days.

    Thanks for your help. I really enjoyed the article. It was very helpful.



  14. Harry says

    HMC – No I would not do the $50k refi as you outlined. I would ask the bank about their home equity loan. If they still charge a high closing cost, I would consider the two options with PenFed in the article (solutions #2 and #3). Or if you have cash, just pay it off. Even at 2.75%, you can’t get 2.75% on your savings these days.

  15. Big C says

    Reference article in Finance Buff, “The Best Way to Refinance a Mortgage” submitted by Harry Sit. Harry saved me over $4000 in interest payments. Harry’s article pompted me to check Pentagon Federal Credit Union (PFCU) and I found it offered a 5 year home equity loan at 1.99%.

    I had a $35,000 15 yr mortgage financed at 5% last payment due 10/01/02019. Paid the mortgage off through PFCU with a home equity loan of $35,050 @ 1.99% for 5 years….Resulting in increased monthly payments by $92.46, but last payment due 02/01/2018 and best of all $4349 saved in interest.

    Having a 835 credit score and a loan to value ratio of 12% probably helped the process but still..The loan cost me nothing, I did everything on line and had a closing date within 2 weeks of starting the process.

    Thank you Harry Sit!

  16. John Corduff says

    I owe $9500 on my mortgage but have a lot of cc debt -would like to cash-out refi with no appraisal to pay off at least a chunk of my cc debt as the recent town reassessment on my tiny home was $70,500 (down from a high of $106,00). I have good credit, have always paid my bills – just don’t see the need for appraisal – do you think Penfed would do this for me? What would be the best product for me? I would like $32,000 cash out to pay most of my debt.

  17. Harry says

    John – I think so. If your loan-to-value ratio is low enough you can get appraisal waived. Home Equity Loan looks like the best but call them and ask.

  18. Zach says


    Does anyone know if PenFed still has the NO Closing Cost 5/5 ARM? I cuurently have a 15-year FHA with about 12 years $54k left on it. I want to re-finance in order to be eligible for an FHA again if I move to another city/state for work (very likely). DOes anyone have any advice for me? I would love to re-finance with no costs.


    • Harry Sit says

      Call them. The closing cost credit offer on the 5/5 ARM comes and goes. If it’s not offered now, maybe you can ask them to contact you when it’s offered again.

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