Mortgage Q&A: Refinance numbers all relative

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Q. Your recent column about disappointing appraisal reports was interesting. We are in the process of refinancing and our appraisal came in $40,000 under what we thought our property was worth.

I spoke with the appraiser and unfortunately, he convinced me his assessment is probably accurate. The result forces us to pay a rate that’s 0.25 percent higher. This doesn’t kill the deal, but I’m wondering if we should just pay the loan down to get the 75 percent loan-to-value ratio necessary to get the best rate.

A. I know I sound like a nerd, but this is why I like numbers. They don’t lie, cheat or steal. They are based on a set of assumptions. Beware, however, because the assumptions can lie, cheat and steal.

Here are some questions to ask yourself:

  • How much money is necessary to get the better rate?
  • What kind of return are you currently making on the money that would go into your home’s equity?
  • What’s the annual interest savings between the two offered interest rates?
  • Will the cash transfer to equity in your home put you in an unbalanced position regarding your liquidity?

One simple calculation is to take the annual interest savings between the two rates and divide it by the amount of cash you need to reduce your mortgage debt.

If, for example, you need to reduce your debt by $20,000 and your interest savings to do so is only $500, you’d only be “making” 2.5 percent on your money ($500 divided by $20,000 equals .025).

You are not alone in this predicament. I have a client who made a refi application with me and expected to pay his loan down by $20,000 based on his estimate of the property’s value. The appraisal report that came in required him to pay $27,000.

Undoubtedly, he was disappointed, but he didn’t question the validity of the report. He has plenty of money in the bank and I obviously urged him to continue with the refi process. He hesitated. I don’t blame him. It’s a disappointment. Then, I spelled out the numbers.

He’s refinancing a 4.75 percent rate with a $125 monthly private mortgage insurance payment (PMI) to a 4.25 percent rate with no PMI. His current rate with PMI is equivalent to a rate of about 5.875 percent with no PMI.

A drop from 5.875 percent to 4.25 percent is a very significant 1.625 percentage points. The annual interest savings is about $4,000. I first tell him that the $27,000 transfer saves him $4,000, thus earns a return of 14.81 percent ($4,000/$27,000). Not bad.

I then illustrate the cash flow. By doing the refi and dropping his mortgage debt by $27,000, his monthly payment drops by $400. I suggested that he continue with the refi and use the $400 monthly savings to replenish his savings account - $400 x 18 months = $7,200.

I told him that in a mere 1½ years, his savings account will be back to pre-refinance levels, he will be $7,000 less in debt, and his mortgage rate will be 4.25 percent rather than 5.875 percent for the remaining term.

It’s a no-brainer.

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

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