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.
Conclusion
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.
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Money Beagle says
I would re-finance in a heartbeat if it were possible, but the equity in our house is well below what the banks would consider in giving us a PMI-free loan w/o escrow (which is what we have today due to the fact that we put 20% down at the time). If I were able to re-finance I would absolutely consider an ARM. Even if rates were higher a few years down the road, the amount of principle I’d be able to pay down in the mean time would most likely well offset any possible uptick down the road.
David says
Very interesting analysis. Did you consider the PenFed 5/5 ARM? If so I’m curious about your thoughts on that. I’ve looked at that over the last few years whenever there was a dip in rates but I always ended up going with the “safer” fixed rate loan.
Harry Sit says
@David – Yes I considered PenFed’s 5/5 ARM. It’s currently 3.25% for the first five years, versus 2.625% on the 5/1 ARM from FirstIB. If I’m going to pay 3.25%, I might as well get the 10-year fixed at 3.25% from FirstIB with no closing cost. For my loan, the PenFed 5/5 ARM isn’t as good as the offers from FirstIB.
Mike says
Interesting strategy. What is the max. LTV ratio you can cash out without being penalized?
Harry Sit says
@Mike – 60%.
TJ says
Has teh no closing cost expired? I don’t seem to see that option…
Harry Sit says
@TJ – FirstIB only lists rates with closing cost. The next higher rate will have no closing cost. For example if the highest rate (lowest fees) listed is 3.5%, 3.625% will have no closing cost.
enonymous says
good analysis
of course 60% LTV, and small enough balance to be able to payoff the loan with a balloon payment at the end of the 5 years is the key
the Penfed 5/5 is a tremendous deal at 3.25% (if that is stll there) especially for those with jumbo mortgages. but it is not a great deal for those in TFBs exact situation…
I’m in a 15 yr fixed, doing the refi thing yet again (always no closing costs), and the 5/5 or 5/1 or even 7/1 ARMs didn’t make sense to me, largely because I’m unwilling to to make the large balloon payment needed to be safe with a 5/1 or 7/1, and because the 3.25 5/5 ARM isn’t low enough to entice me from my 3.75% 15 yr fixed…
ChrisCD says
Forgive me, but I am unclear how the no-closing costs deal works. Every time I have looked they have wanted to wrap the costs into the loan which isn’t what I am looking to do.
In addition, our home value has dropped low enough to make it the option seem out of reach.
cd :O)
Heidi says
Money Beagle – I was in a similar situation. After calling several banks (because their website calculators consistently concluded that I would not qualify for their mortgage due to my LTV), I found Connexus Credit Union. They let me do an 80/20 to avoid PMI just last December and I saved over a $1,000 a month on my super jumbo mortgage. I have since paid off the HELOC and am paying off the 25 year 3/3 ARM over a 10 year amortization. You might want to try giving them a call.
Madison says
I keep lowering our 5/5 ARM at penfed with a plan to pay off in 5-10 years. And just like you, I thought every time it couldn’t go lower. We’re at 3.375% on our 5/5, and now of course, I see rates are even lower again!
I’ll have to check out FirstIB, I hadn’t looked into their ARMs lately.
TJ says
@TFB – I see an option with no points, but this option still has $2k in fees (origination charge, appraisal, credit report, flood cert, title insurance, government recording charges)
Harry Sit says
@TJ – If you want the no cost option, add 0.125% to the highest rate listed. You have to call them.
TJ says
@TFB do you have any experience with boxhomeloans. com?
I got better rates for a 30 year than any other sites. I locked it but because it was “after hours” (the weekend), they can’t confirm until Monday, if it is lower than what i locked, mine will be the lower rate, if rates go on monday, they will ignore my request and I have to resubmit a lock request.
Harry Sit says
@TJ – Sorry, I don’t have any experience with Box Home Loans. Maybe check the FatWallet thread?
super bill says
First IB looks appealing for a 5/1 ARM. However, I live in Maryland and it seems that they do not lend here. Do you know if this is true and if so, could you recommend other institutions? I am seriously considering the PenFed 5/5 at 3.125% with no closing… Thanks for a great site.
Harry Sit says
@super bill – Several other readers also reported the same thing. You can always call their 800 number to confirm if it’s still the case. If so, go with PenFed then. Maryland has a transfer tax. It’ll be very difficult to beat the PenFed rate when you include the transfer tax, which PenFed says it covers.
“5/5 Adjustable Rate Mortgage (ARM) Promotion: We will pay closing costs up to $10,000 per loan, to include: Appraisal fee, Tax Service Fee, CLO Access Fee, Title Fees, Transfer Tax Fees, Credit Report Fee, Flood Cert Fee, Recording Fee, Survey if required and Work Verification Fee.”
super bill says
TFB – just wanted to follow up on my posting. I appled for the PenFed 5/5, which seemed great, but their appraisal came in way low – about 120k under what our last appraisal was one year ago. Therefore, our loan amount exceeds their limit given the valuation. I am trying to appeal but in the meantime, wanted to see if you or others had other suggestions for a 5/1ARM or interest only product with no closing costs? (BTW, I checked with FirstIB, and they do not lend to MD) Thanks again.
Harry Sit says
@super bill – Too bad the PenFed appraisal came in low. I hope you will be able to successfully appeal it. Maybe they can request another one? The other two lenders on my short list to check are NMA (nmaloans.com) and AmeriSave (amerisave.com). Also check the [long] FatWallet thread.
Jc says
If my lyv is 50% and I refi from a 30 to a 15yr fix, and cash out 50,000 and then pay back the 50,000 towards the principal, it seems i will be saving a huge amount of interest every month. Is there a draw back to this besides a higher monthly payment?
Thx
Harry Sit says
Jc – No.