New Refinancing Fee Set For February

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During the past few years we have seen generally rising home values and lots of consumer spending. A portion of that consumer spending has been translated into new mortgage debt, financing used for purposes other than to acquire a property.

In environment with rising home values and low interest levels, the urge to refinance makes perfect sense. In many cases, high-cost credit-card debt is being converted into low-cost, tax-deductible home equity financing, a logical financial option.

But now Fannie Mae has decided to change its refinancing rules beginning February 1, 2003. This is important because Fannie Mae is the largest mortgage buyer in the country, so its decisions are often duplicated by other loan purchasers, so-called "secondary" lenders.

In general terms, there are two forms of residential refinancing: rate-and-term refinancing and cash-out refinancing. In the first case, the borrower wants a lower rate, a shorter payment term (say 15 years rather than 30), or reduced monthly costs. What the rate-and-termer does not want is more debt other than closing costs to settle the new loan.

In the second case, the borrower may also want a lower rate, a shorter payment term and lower monthly costs. However, in this situation the borrower also wants to finance more than the remaining loan amount, maybe going from $150,000 in mortgage debt to $200,000. The additional money is then used to pay off credit card debt and other expenses.

A study by Fannie Mae has found that when homeowners refinanced and increased their debt amount by at least 20 percent, the default rate was three times greater than cash-and-term refinances where debt was increased 3 percent or less.

As a result, beginning February 1, 2003 Fannie Mae will essentially divide cash out options into two categories: cash-out refinancing in general and "limited cash-out" refinancing.

With a "limited cash-out" the homeowner is refinancing current debt to get that lower rate, smaller payment or shorter loan term. However, Fannie Mae is defining "current debt" as the original financing used to acquire the property, say a first mortgage or perhaps a first mortgage and a piggy-back loan. This definition does not include other real estate loans, perhaps a home equity mortgage, a home improvement loan, or a home equity line of credit. Thus, says Fannie Mae, "the limited cash out refinance category will include only those loans that involve:

• the pay-off of the outstanding principal balance of an existing first mortgage,

• the pay off of the outstanding principal balance of any existing subordinate mortgage that was used in whole to acquire the subject property,

• the financing of closing costs (including prepaid expenses), and

• cash back to the borrower in an amount no more than the lesser of 2% of the balance of the new refinance mortgage or $2,000."

What does it all mean?

One view is that Fannie Mae is seeking more compensation in the face of greater risk. That's a normal and natural reaction by anyone who makes or holds loans.

A second view is that a greater cost is a greater cost. You can call it anything you want, explain it anyway you like, and the result is the same: all other costs being equal an additional fee for refinancing means more money from the borrower.

The impact of the new fee is difficult to judge. Certainly if you are a borrower and have a choice of higher costs or lower costs, you would prefer the latter. The catch is that you can't just look at one cost in isolation, you have to consider the total expenses you might face by refinancing.

Imagine that for a $100,000 cash-out refinance you have an extra .75 percent cost at closing. You can either pay $750 in cash up-front or increase the loan amount by $750.

If you hold the loan for 10 years, the additional cash cost is $6.25 per month ($750 divided by 120 months). This one-time $750 expense might be deductible in the year paid as a loan discount fee (see a tax pro for details). However, be aware that if you pay cash up front there is an "opportunity cost," the interest or other advantage you might get if the money could be used for something rather than closing the loan.

Instead of paying at closing, if you borrow $750, add it to the loan amount, and amortize it over 10 years at 6 percent interest, the monthly bill would be $8.33 or a total cost of $999.60, an expense which may be deductible.

But also imagine that you refinance and cut your interest rate by 1 percent. For a $100,000 debt, you would initially save almost $1,000 a year.

Refinancing includes a number of costs and expenses. To see if refinancing works for you, it pays to look at overall closing expenses and monthly savings. For instance, if it costs $5,000 to refinance including $750 for a cash-out refi but you save $150 a month, then the cost of refinancing would be absorbed in a little less than three years (33.3 months). If you think you will continue living in the property for 34 months, then refinancing can be attractive.

To figure out whether to refinance or not you need to know the full package price of the new mortgage -- the total of what it costs to close, what you will save in terms of lower monthly payments, and the cost of any prepayment fees. Shop around, run the numbers for the decision which is best for you, and consider refinancing before February 1st.