What to Expect When Refinancing Your Mortgage

This post is part of an ongoing series on getting my financial house in order.  In this post I’m going to cover all the ins and outs of refinancing your mortgage and talk about my most recent refinancing experience.

I bought my home in 2004 and since then I’ve refinanced it twice.  The first refinance was in 2007 and my goals at the time were to switch from an adjustable rate mortgage (ARM) to a fixed rate mortgage,  get rid of private mortgage insurance (PMI), and switch to a 15 year loan so that I could save money and pay the house off quicker.  I just got done refinancing again and this time the goal was to simply reduce my interest rate and save even more money.  These are all great reasons to consider refinancing and if any of these sound like things you’d want to do, read on and I’ll walk you through the process.

Getting Your Ducks in a Row

When you’re applying for a loan you’re going to need to have some info on hand.  These are the key bits:

  • Loan amount (how much you want to borrow, likely the payoff of your current loan).
  • Approximate value of your home (get this from Zillow.com).
  • Do you want an escrow account with your new loan?  Your escrow account is the account that your lender uses to pay your property taxes and homeowners insurance with. You will probably want one and your lender probably requires it anyway.  There doesn’t seem to be any benefits to paying these yourself anyway unless you’re trying to game the tax system by timing your property tax payments so that two land within the same tax year.
  • When did you buy your home and what did you pay for it?
  • About how much do you pay per year in property taxes (you can usually get this online from the county assessors office or from your current lenders escrow statement).
  • Do you currently pay for a homeowners association (HOA) and if so what does it cost monthly?
  • Employment history for the last 5 years or so (employment start dates, how much you made, etc).
  • How do you intend to pay for closing costs?  Closing costs will be in the neighborhood of $2,500-$3,500.  These can probably be rolled into the new loan, but if you can, pay for them with cash on hand so that you’re not paying interest on that money.
  • What are your expenses (credit cards, loans, and leases)?  You don’t need to put in things like monthly utility payments here, these are generally expenses like other debts you’re paying on.

Next you need to figure how long you want your new loan to be for.  You want to try and get the shortest loan you can afford, but also consider how long you really intend to keep the loan.  For example, if you know that you’re going to move in 5 years, you might opt for a 5/1 adjustable rate mortgage (ARM) (5 years locked interest rate, then changes every year thereafter).  Sometimes the ARM loans have lower interest rates than the fixed rate loans, but sometimes they don’t, so compare both.  In general I like to stick with fixed rate loans but everyone’s situation is different.

So how do you figure out what you can afford?  Use an amortization calculator to calculate out what your monthly cost would be.  My favorite calculator is this guys.  Get the shortest loan that you can afford.  You will save a ton of money that way.  Here’s a comparison to illustrate:

Loan 1: $100,000, 30 years @ 4% interest
Loan 2: $100,000, 15 years @ 4% interest

With loan 1 your monthly payment would be $477.42 (not including your escrow amount) and if you were to keep the loan the full 30 years you would have paid a total of $171,871.20 for the loan.

With loan 2 your monthly payment would be $739.69 (not including escrow) and you’d end up paying $133,144.20 for the loan.  In other words, if you can swing another $262.27 a month, you could cut your loan length in half and save $38,727.00 in interest!

Another thing to consider when choosing loan length is that you can almost always make additional principal payments without penalty.  Where this comes into play is when a lender is offering a really great rate on say a 20 year loan, but you really only want a 15 year loan.  If you’re disciplined and make additional principal payments, you could pay the 20 year loan off in 15 years and the overall cost might end up lower.  Here’s an example:

Loan 1: $100,000, 20 years @ 3%
Loan 2: $100,000, 15 years @ 3.5%

Loan 1 would be $554.60 per month and cost you a total of $33,104.00 in interest.  Loan 2 would be $714.88 per month and cost you a total of $28,678.40 in interest.  Now let’s say you went with the first loan.  If you paid an extra $138.00 per month you’d have the loan paid off in 15 years and your total monthly payment would still be lower than loan 2’s payment.  You’d also save $8,893 in interest by paying it off earlier, bringing the total interest cost down to $24,211.00, that’s a savings of $4,467.00 compared to loan 2.  I used this calculator to calculate the early payoff savings.

Shopping for a Lender

Before you go submitting a bunch of applications, do some shopping around.  You should narrow your search down to a few lenders before you apply because you don’t want to reduce your credit score by applying at a bunch of places.  Oh, and don’t do anything that would mess with your credit in general, like open up a new credit card or get a new car loan.  Lenders do a last minute credit check before finalizing your new loan and anything that has changed since you applied for the loan will throw up a red flag and slow things down.

For my refinance I decided to go with Pentagon Federal Credit Union (PenFed).  I learned of them a few years ago when shopping for a car loan and I’m so glad I stumbled across them.  They are a no-nonsense type of credit union.  Low rates, good customer service, no added frills or schemes to rip you off.  Prior to PenFed I was using Desert Schools Credit Union for my mortgage and auto loans.  They’re fine too, but PenFed’s rates are better and their web site isn’t stuck in the stone ages like Desert Schools’ is.  My advice would be to shop around different credit unions and check out some of the rates listed on bankrate.com, then compare them to PenFed.  I think you’ll like PenFed.  BTW, you don’t have to be a member of the military to join PenFed, you can make a one time donation of $15 to a charity when signing up to become a member.

When comparing loan offers, you’ll first want to look at the Annual Percentage Rate (APR).  The APR basically factors in the interest rate of the loan, some of the closing costs, and any discount points you pay so that you can get a better idea of what the loan is really going to cost you.

I just mentioned discount points, so lets explain what those are.  The general idea behind points is that you can pay a “point” to reduce the interest rate of your loan.  Each point represents 1% of the total amount you’re borrowing, so if you’re borrowing $100,000, each point will cost you $1,000.  If you can afford to pay points and the reduction in interest will save you some money, go for it.  However, pay close attention to the overall APR because sometimes the lower interest rate doesn’t save you any money after all.  For example, here are two different loan offers I found from the same bank, one with points and one without:

Loan 1: $100,000, 10 years @ 2.625%, no points.
Loan 2: $100,000, 10 years @ 2.375%, 2.875% points.

Loan 1 is going to end up costing $13,806.80 in interest if you kept the loan the entire 10 years.  Loan 2 is going to end up costing $12,443.60 in interest plus you need to pay an extra $2,375.00 for the points, so overall loan 2 is going to cost you $14,818.60, which is more than loan 1.

You also want to try and get an idea of the closing costs that the lender is going to want to charge you.  Sometimes lenders will give you an estimate before you apply, sometimes you have to wait until the application has gone through and the lender has provided you with a good faith estimate which breaks out the closing costs.  Again the APR should give you a general sense of their closing costs, just know that lenders don’t always include all of their closing costs in the APR.

Applying for the Loan

Now that you’ve got your ducks lined up and a potential lender or two picked out, it’s time to submit your application.  When I applied through PenFed, I just submitted the application online.

One of the things they asked me for was a debit or credit card that they would charge for any third party fees like running my credit check.  If you apply at a few different places you might have to pay for a couple credit checks at about $10 a pop, but normally that cost is rolled into your closing costs if you go through with the loan.

Another thing they asked was whether or not I wanted to lock in my interest rate.  I personally am not much of a gambler, so I like to lock in the rate right away.

They also asked if I was interested in making bi-weekly payments versus monthly.  I think there is nothing wrong with doing bi-weekly payments, just know that all you’re really doing is making an extra small payment each year.  You’ll shorten the loan a little bit and save a little on interest, but most lenders will also let you just do additional principal payments whenever you want or include an additional principal payment with your monthly payment too.  I’d rather control when I make the additional payment then get locked into a payment plan.

After you’ve submitted your application, if you’ve been pre-approved, you should get some paperwork from the lender explaining the details of the loan application.  The most useful document you’ll get is the Good Faith Estimate (GFE).  The Good Faith Estimate shows the general terms of the loan and forces the lender to disclose any shady type stuff they might be trying to pull, like charging prepayment penalties and anything that might change your interest rate during the loan.  Another piece of useful information on this form is the origination fee.  That is the amount of money the lender is charging you up front to give you the loan.  You should also see a breakdown of your other settlement charges, like home appraisal, title insurance, and the initial deposit for your escrow account.

One thing that can be confusing is settlement charges versus closing costs.  When you are comparing loans and the lender gives you an estimated closing cost, these are generally the things they include in that number:

  • Loan origination (what the bank charges to give you the loan)
  • Points you pay to get the loan
  • Home appraisal
  • Credit report
  • Tax service
  • Flood certification
  • Title insurance
  • Government recording

However, they don’t generally include things like:

  • Initial deposit for escrow account
  • Daily interest charges

So when you’re comparing closing costs between lenders, you’ll want to exclude things like escrow charges and daily interest charges.  One thing to note here too is that you’ll likely get some money back from your current lender when you pay off the existing loan because they’re going to refund you whatever was already in your escrow account.

Another thing to be aware of is how the daily interest charges work.  First we’ll look at daily interest charges on your existing loan, this is separate from the interest charges on your good faith estimate.  Let’s say you currently pay your mortgage payment on the 1st of each month.  You apply for your refinance loan on June 1st and your loan ends up closing on June 15th.  Your current lender is going to want you to pay off the principal balance of your loan plus any daily interest between your last payment and when you actually paid off the loan, so in this case 15 days of additional interest.

Now we can look at the daily interest charges on the good faith estimate.  These are interest charges for the days between when the loan closes and the day that your first mortgage payment is due.  Usually banks will make your first payment due on the first of the month following a full month from your closing date.  For example, if your loan closed on June 15th, your first mortgage payment would be due on August 1st.  The reason they throw a full month in there is because mortgage interest is paid in arrears, so your August payment will actually be paying for July’s interest.  What happens to those 15 days left over in June?  Those are your daily interest charges that the good faith estimate is talking about.

Processing Your Loan Application

The next thing that should happen is that you’ll be assigned a loan processor.  This is the person which is going to walk you through the rest of the loan process.  When I applied at PenFed, my loan processor asked me send him the following:

  • Copies of my most recent pay statements.
  • Copies of the last two years W2s.
  • Bank statements from the last two months.
  • Verification of liquid assets that I’d use for closing costs.  In my case this was coming out of my checking account.
  • A copy of my homeowners insurance policy showing PenFed and the new loan number within the mortgagee clause.  I had to call my insurance company and actually switch this over to PenFed.
  • An HOA statement showing that I’m current on my homeowners association dues.

The loan processor also arranged to have a home appraisal done and I received a call from the appraisal company within about a week or so to schedule their visit.  The appraisal guy came out and checked out the property and took a few pictures.  He was there maybe 30 minutes.

Once your loan processor has everything and has processed it all, they should sent you a Settlement Statement (HUD-1) that breaks down all the near-final figures for your loan.

Closing on the Loan

Once the loan application has been completed, your loan processor will ask your current lender for loan payoff statement.  It’s a good idea to ask your processor for a copy of this for your records.  When I received a copy of my loan payoff I noticed that my old bank was charging a $25 payoff fee and a $10 recording fee.  Of course my loan with them was supposed to have no prepayment penalty, so I don’t know how they can get away with charging a payoff fee, but not worth worrying about.

The final step is to sign all the loan paperwork and finalize the loan agreement.  Generally you go down to the title insurance company and sign all your paperwork.  This time around, since PenFed is their own title insurance company and they don’t have any branches where I live, they arranged to have a third party company handle the signing.  The company they used gave me the option of meeting them somewhere or just coming out to my home.  I opted to have them come out to my home which worked out great.  My wife and I signed a mountain of paperwork and it was done.  Refinance your mortgage achievement unlocked!

Final Thoughts

For me the entire process took about a month.  I refinanced my 15 year loan @ 6.125% (I had 7.5 years left on it) into a 10 year loan @ 2.75%.  When it was all said and done, I paid $3,680.58 out of pocket at settlement: $2,537.71 in closing costs and $1,142.87 in prepaid items (escrow items and daily interest).  I got back about $800 from my previous lender when they refunded what was in my old escrow account.  I also had a month where I didn’t have a mortgage payment of about $1,300 too, so really I only had to float about $1,500 overall and I should make that back from the savings on my new loan within 5 months.

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