Q:My wife and I are over 50 and our children are grown. We recently
refinanced an 8 percent fixed rate with a balance of $100,000 to a balance of $225,000 with a variable rate at an APR of 7.45 percent.
The total closing costs
The rate is fixed for the next two years but after that it will go up 3 percent.
We now think we made a mistake by taking out the adjustable-rate loan. We own a rental property with no mortgage in South Carolina.
Do you think it would be wise to take out a fixed-rate loan on our rental property and pay off our mortgage here in Maryland? Or should we wait two years and refinance the Maryland loan before the rate rises?
A: It’s difficult to give conclusive advice because I seldom know the full story, but let’s go over a few things.
You refinanced the mortgage on your primary residence from an 8 percent fixed rate to a adjustable rate with an “APR” of 7.45 percent. You also took cash out by increasing your loan balance by about $125,000.
Obtaining cash by tapping into equity is perfectly OK, as long as you have a good reason to do so. But why did you refinance to an adjustable rate mortgage (ARM)?
Let’s first talk about “APR,” annual percentage rate. The APR is supposed to give the borrower the true cost of credit after taking into consideration not just the interest rate on the note, but also any fees associated with the transaction.
In theory, a consumer should be able to shop for a mortgage by comparing the APR. Unfortunately, it doesn’t work as a practical exercise for a variety of reasons.
First, the APR can only be estimated by the lender at the time of application. Many fees associated with obtaining the loan are not directly controlled by the lender. This can make the lender’s estimate inaccurate.
Second, it’s impossible to determine a true APR on an ARM because it’s impossible to determine where the interest rate will go at the time of adjustment.
Third, and most important, even if the transactional costs are exactly known and the mortgage carries a fixed rate, the APR is virtually useless because the APR assumes that the borrower will hold the loan to the end of the term.
Consider this example: A borrower shops around for a mortgage. He finds two options. The first carries a fixed note rate of 5 percent for 30 years. The APR is 5.50 percent because the loan requires $12,000 in points and fees.
The second option carries a fixed note rate of 5.50 percent. The APR is 5.625 percent, only slightly higher than the first loan because the total fees are only $1,000.
Shopping for the lowest APR would mean that the lower rate, higher fee loan is best. But is it? Perhaps, if you hold the loan for the full 30 years. The APR suggests that the overall borrowing cost is cheaper if you sink $12,000 upfront to obtain a lower note rate that will be amortized over the full term.
The problem is that very few homeowners will hold a mortgage for the full term. Most folks either move or refinance at least once within 30 years. Points and closing costs are never refundable, so if the loan is paid off early, the true APR would have to be calculated by taking into consideration the shorter time that the lower interest was paid in addition to the full upfront costs.
The APR makes unrealistic and incorrect assumptions. That’s the bottom line, and, frankly, I get steamed when I hear the so-called financial “experts” on late-night TV spouting the nonsense that one should compare the APR when shopping for a mortgage.
Since you have already refinanced to the ARM and forked out almost $7,000 in costs, I would hesitate to refinance again unless you can obtain a lower rate with little or no fees. Unless your ARM is very unusual, I doubt if your rate will automatically increase 3 percentage points in two years. The terms of the note probably cap the adjustment at 3 percent, but the true adjustment will be a function of the interest rate environment at the time.
It’s clear from your e-mail that you don’t have a complete understanding of the terms of your mortgage. This would suggest that your loan officer was either unethical or inept.
My advice would be to ask trusted sources such as friends or family members to recommend a good mortgage broker or lender. A good loan officer will be able to dissect your current situation, ascertain your objectives, and recommend what, if any, course of action you should take.
Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (firstname.lastname@example.org).