What's Behind Your Refinance Rate?
May 06, 2010
Plenty of mortgage calculators show you how to ballpark whether refinancing will save you money: plug in your existing mortgage rate and loan term, plug in your proposed new mortgage rate and loan term, and see how much you save per month. Easy, right? But particularly if you took out your existing mortgage before the housing bust, refinancing in today's market may seem less than straightforward.
What goes into your new mortgage rate? What if the value of your house has gone down?
Understanding how mortgage lenders and mortgage brokers view risk in the post-housing bust world can help you compare mortgage rates and make refinancing decisions more easily.
Risk and Your Mortgage Rate
Conventional financing--meaning a loan secured by one of the two government-sponsored entities, Fannie Mae or Freddie Mac--is risk-based financing. The underlying concept is similar to how auto insurance works: the riskier you are to insure, the higher your premiums. For example, if you drive a sports car or have a bad driving record, you will pay a higher insurance premium. Home mortgage rates work the same way. If you have a jumbo loan (that is, a loan amount higher than $417,000) or a bad credit history (as reflected by a lower credit score), you could also expect to pay more.
To quantify the price of different risk factors, lenders use a standard conventional loan matrix. In such a matrix, various risk factors are listed, along with how each can affect a borrower's mortgage rate. Standard risk factors include:
- The loan-to-value (LTV) ratio. The LTV is the amount being borrowed divided by the value of the property; the higher the LTV, the bigger the risk to the lender.
- Whether the transaction is a cash-out refinance or rate-and-term refinance. A cash-out refinance is one in which non-mortgage debts are being paid off. A rate-and-term refinance is one in which only the borrower's existing mortgage debt is paid off and any cash proceeds are less than $2,000.
- The credit score of the borrower. Your credit score is one of the most significant determining factors for your mortgage rate.
- The occupancy status of the property. Is the property your primary residence, a second home, or an investment property generating income? A lender will view these differently.
What can some of these factors cost? Take, for example, the penalty for a credit score that is between 640 and 660 for a loan-to-value of 75%. According to Home Savings of America, the penalty for this is 1.5 points, or 1.5% of the loan amount--hardly trivial when determining whether savings from a refinance is worth its cost.
Points vs. Higher Mortgage Rates
If you're the homeowner in the situation above, you could always take a higher mortgage rate to cover the cost of the lower credit score penalty. Unfortunately, there is no standard, fixed tradeoff between a reduction in cost (points) and an increase in mortgage rates. Nobody can predict exactly how much the rate on your mortgage will need to go up to cover the 1.5% cost: It all depends on market pricing the day you speak with your lender or broker.
At times, going from a 5% interest rate to a 5.125% interest rate can cost 0.75% (0.75 points), and at other times, it may be only 0.125% (0.125 points). It all depends on how mortgage-backed securities are being traded that day--or more simply, on prevailing supply and demand for mortgage debt. That's why it's important to stay in communication with your mortgage professional and determine the best strategy for your refinance.
