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 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. Because your loan size is higher now, although spread over a longer loan term, your required monthly payment may be higher.
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.
Pentagon Federal Credit Union (PenFed) offers a home equity loan for owner-occupied homes at maximum 80% LTV at good rates. 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, the rate for a 10-year home equity loan 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. 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. A 5/1 ARM I used to have would adjust with “5/2/5” which means the rate could jump by 5% at the very first adjustment.
Suppose the rate on PenFed’s 5/5 ARM is 3.00% for the first five years. With it capped at 2% higher, i.e. 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.
Sometimes PenFed will run a promotion and offer to pay all closing costs on their 5/5 ARM unless you are refinancing an existing PenFed mortgage. It’s better if you refinance your small loan when PenFed is running the no closing cost promotion.
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.