Mortgage Q&A: Client fails refi math test

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Last week, I applauded the fact that interest rates are low, and I pointed out that it’s not helping the sluggish real estate market. I also noted that the drop in property values is prompting some homeowners to make some bad decisions.

Let me share an interesting series of events that recently occurred with one of my potential clients.

George and Martha came into my office to make a loan application for a refinance. They have a $412,000 loan balance on an adjustable-rate mortgage (ARM) with a current rate of 5 percent that is due to adjust in 3 1/2 years. They have an interest-only payment option they want to keep because they want the lowest possible payment.

I offered them a 5/1 ARM at 3.625 percent with an interest-only option and no closing costs. This program saves them $472 in monthly interest payments and gives them an additional 18 months before the rate would adjust.

I told them the property must appraise for at least $589,000 to be eligible for the loan. They were certain the property would appraise for more than $600,000.

We signed the paperwork, and the appraiser inspected the property and sent me the appraisal report, which valued the home at just $500,000. George and Martha are furious, but after speaking with the appraiser, they realized their expectations had been a bit high.

Because I had their application information, I could see they have good income and more than $500,000 invested in securities. While I realized their two objectives in refinancing were to lower the interest rate and monthly payment, I suggested they consider paying down their balance by $12,000, to $400,000. That move would make the loan-to-value ratio on the home 80 percent, and they would be able to refinance to a 5/1 ARM that amortizes over 30 years. The rate, with no closing costs, would drop to 3.50 percent.

The problem was that they would have to withdraw $12,000 from their investment portfolio, and their payment, because it would be paying down principal instead of interest only, would rise by $135 per month. However, at the end of 3.5 years, when their existing ARM is due to adjust, they would have gained more than $40,000 in equity. (The loan balance, by kicking in $12,000 initially and paying an extra $135 per month for the next 3.5 years, would fall from $412,000 to about $372,000. That’s a $40,000 decrease in debt - or increase in equity.)

The overall cash outlay would equal about $18,000 ($12,000 initially plus $135 over 42 months). I pointed out that this investment of equity into the house makes a guaranteed return of more than 30 percent annually.

Without going into the time value of money, let me illustrate how I arrive at the return. A total cash investment of $18,000 returns $40,000 over 3.5 years. To calculate the annual return, you take the difference between the investment and the total return ($40,000-$18,000 = $22,000), divide it by 42 months, multiply by 12 months and divide by $18,000 (the original investment). This gives you a 34 percent annual return.

My potential client responded by saying it would be foolish to pay down a mortgage when real estate values are dropping. I told him real estate values don’t know and don’t care if there’s a mortgage on the property.

The value of the property is going to do what it’s going to do. Interest saved is interest earned. If his $500,000 portfolio isn’t making a 34 percent return, he should pull $12,000, plus $135 per month in order to build $40,000 of equity in his home.

I’ve heard it a million times. Folks seem to bind together their mortgage and the appreciation or depreciation of their home. That’s not an issue unless you are a danger of foreclosure.

Henry Savage is president of PMC Mortgage in Alexandria. Send email to henrysavage@pmcmortgage.com.

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