To Refinance or Not To Refinance (part 2)

Yesterday we went over some of the reasons why the current low interest rates are unlikely to spur a dramatic wave of refinancing activity. However, trying to capture a lower interest rate may make sense for homeowners that have equity in their property, strong credit scores and available cash. Today we’re going to run some numbers to try to quantify the benefit of a lower interest rate.

Assumptions
1. Homeowner purchased a home one year ago using a 30-year fixed mortgage at 6.5%.
2. Homeowner will refinance into another 30-year fixed mortgage at a lower interest rate.
3. Refinancing will cost \$2,500 in non-recoverable closing costs.
4. Ignore situation-specific factors like PMI, and unaffected factors like taxes and insurance.

Question
Would the homeowner benefit from refinancing?

Analysis
The key to understanding if a refinancing is worthwhile is comparing the savings in the monthly mortgage payment with the up-front closing costs. As long as the monthly savings are sufficient to quickly pay off the initial investment, then the homeowner benefits. I created an Excel worksheet to compare the initial investment to the monthly savings and then use those two values to calculate how long it would take for the monthly savings to pay off the closing costs.

The chart above shows how many months of lower payments (savings) it would take to offset the initial \$2,500 in closing costs. Each row represents a mortgage amount (not home price) and each column represents a potential new interest rate for the refinanced loan. For example, if I had taken out a \$300,000 mortgage last year at 6.5%, and refinanced to a 5.25% rate, then it would take 12 months of lower payments to recover my investment in closing costs.

Discussion
The benefit of refinancing clearly depends on the size of the mortgage. Larger mortgages have higher payments, so cutting the rate means larger monthly savings. Since the closing costs are generally independent of mortgage size (assuming the lender rolls their fees into the interest rate), the payback period is shorter for larger mortgages.

We can also see that the payback time is relatively short. If you could drop your rate by 1.0% (from 6.5% to 5.5%), then you would make back the closing costs within 2 years (24 months) for mortgage amounts all the way down to \$200,000. This is another way to say that refinancing would be valuable as long as you are planning to keep your current mortgage for at least 2 years.

Finally, we should also mention the option of paying points to the lender. The points can be assessed for either origination costs or as prepaid interest. Points as prepaid interest generally allow borrowers to get lower interest rates. Paying points changes the dynamic of this calculation because they should be thought of as additional closing costs. These calculations are based on mortgages with zero points.

Despite being a simplistic approach to calculating the benefit, payback is very intuitive to most homeowners. Readers with a background in finance and/or investing may be tempted to enhance the calculations to also consider the time value of money. While I concede that this calculation may slightly overstate the value of refinancing, the difference is small for most people – perhaps a month or two. The two scenarios I can imagine where the time value of money would be an issue are if you have to pass up an incredible investment opportunity to pay closing costs, or if you believe the United States is going to experience very high inflation rates. If you have inside information about either, please feel free to send it my way.

Conclusion
A quick calculation based on a likely scenario shows that there is a benefit to refinancing, and that you don’t have to live in your home forever to capture it. If you are serious about this option, it is important to work with a mortgage professional that can first confirm that you are qualified to refinance in today’s lending environment, and then can walk you through the various options. As I mentioned yesterday, Amy and I know some quality mortgage people – don’t be afraid to ask!

Update: Changed the reason for ignoring PMI in Assumption #4 based on comments.

To Refinance or Not To Refinance (Part 1)

That is the question. Whether ’tis nobler to suffer the slings and arrows of higher monthly interest payments, or to take arms against the current mortgage, and by refinancing, to end it.

Interest rates are back down to historic low levels. The chart at left is from Bankrate.com and shows the average interest rate for 30-year fixed mortgages in Connecticut over the past 5 years. Large mortgage rate drops historically lead to a boom in refinancings, though this time may be a bit different for a few reasons.

1. Many people refinanced back in 2004-2005. There are fewer people paying an interest rate that is considerably higher than current rates.

2. Credit requirements are tighter now. Some borrowers that would like to refinance, and would benefit from lower payments, no longer qualify for a new mortgage.

3. Mortgage products have changed. Lenders are not offering the same variety of products as they were back in the housing “boom” days so borrowers would have to bring additional down payment cash to the closing.

4. Appraised values are falling. Lenders require appraisals before funding a loan because they want to be sure that they know their level of risk, as measured by the Loan-to-Value ratio (LTV). Falling appraisals also lead to borrowers bringing additional down payment cash to closing.

5. Cash is required. In addition to any cash required by the previous two points, homeowners also need to have cash available to pay for the closing and to establish new escrow accounts (for insurance and taxes) while they wait to receive the proceeds from their old escrow accounts.

6. People’s attitudes have changed. As a country we seem less inclined to talk about our financial situations, which should result in fewer refinancings motivated by social pressure to keep up with the Joneses.

With these factors as a backdrop, the first question to consider is whether you CAN refinance. If there is any doubt, and you are serious about trying, then consult a professional. There are plenty of mortgage brokers and mortgage bankers that would be willing to review your personal situation. Amy and I would be happy to provide recommendations for those that do not know someone they can trust.

Tomorrow we’ll continue on the same topic, but actually get into the numbers to see just how much money you could save by refinancing to a lower interest rate.

Hollander Foundation Center Progressing

The next downtown residential project to begin renting is going to be the Hollander Foundation Center at 410 Asylum Street. The drywall is up inside and work crews are making steady progress towards their August 2009 completion goal. Common Ground, the project developer, is currently looking for retail tenants for six ground floor retail suites. Rental applications for the apartments will be available later in the spring.

Plans for 410 Asylum have changed dramatically over the years. Vacant since 1995, previous owners considered a number of possibilities before beginning proposing demolition. In response, the Connecticut Historical Commission obtained an injunction against the demolition. They successfully defended the resulting lawsuit, brought by the owners, as the federal court upheld the property’s inclusion in the High Street Historic District on the National Registry of Historic Places. Eventually the structure was donated to Common Ground for redevelopment.

Even after Common Ground took over, there was still some debate within the City about its appropriate use. All parties agreed that ground floor retail with residential above was ideal, however the City and other local developers expressed concern about bringing “supportive housing” to such a prime location. The building is located on the north end of Bushnell Park with unobstructed views of the Connecticut State Capital Building, which could theoretically make it quite valuable.

But all that is in the past. Construction has been going on for over a year – check out the field report photos – and is nearing completion. Jennifer Hawkins, a very helpful representative of Common Ground, notes that “The building will be a mix of historic restoration with modern “green” features.” It will be LEEDs certified (the first in Hartford) and will be a smoke free building.

When complete, there will be 70 apartment units. Of the total, 56 will be income restricted units in a mix of studios (~494 sqft), one bedrooms (~564 sqft) and two bedrooms (~926 sqft). They will only be available to applicants with income at 60% of area median income. Depending on the number of family members, this translates to tenants earning between \$34,000 and \$43,000. The rent for those units will be set at approximately 30% of income, and include all utilities, access to basement laundry facilities and outside parking.

The other 14 units will rent at market rate and are all two bedroom units (~969 sqft) with in-unit laundry and indoor parking (utilities not included). Rent has not yet been finalized, but initial indications are that it will be about \$1,600 per month. The basic floor plan for the apartments can be seen on the 8th page of this marketing document. You can also see the plans for the six retail spaces on the ground floor. Note that some of the information in the PDF may have changed – the figures I have quoted in the text have all come from a recent series of exchanges with Ms. Hawkins.

Common Ground is planning to have a model apartment available for viewing in May, and to begin accepting rental applications in the June/July timeframe. For now, they are collecting names of interested perspective tenants. For more information, or to be added to the list, call 888-399-8848.

The completion of the Hollander Foundation Center will be an exciting event for Hartford. Not only will it formally announce the arrival of Common Ground, but it will also allow our downtown population to continue to grow. Perhaps most importantly, the project has rehabilitated a vacant historic building and integrated it back into the community. It represents one more step in our slow march to revitalize Hartford’s downtown.

Update: Rents for the affordable units are fixed monthly rates, rather than based on individual tenant income as originally stated.

Update 2: The phone number for the property manager, WinnResidential is 860-548-1167

Hartford's Own Dr. Horace Wells

Close to the pond in the eastern portion of Bushnell Park sits a tall statue of Dr. Horace Wells. The inscription says that in December 1844 he discovered anesthesia. What an odd item to memorialize. Very important, but still a curious choice. I had to look a little deeper. Dr. Wells was a dentist and he lived a life that, if true, should be made into an episode of E! True Hollywood Stories.

According to (the internet) legend …

The art of dentistry was not nearly as refined in the 1840s as it is today. Dr. Wells did not go to medical school, but became a dentist after serving as an apprentice to practicing dentists. He opened his own shop in Hartford in 1836 and even published an essay on teeth. After growing tired of the constant screaming of his patients, he began thinking about ways to reduce their pain.

Nitrous Oxide was a well known gas during the 1840s, and it is said that there were even laughing gas parties where the participants enjoyed the feeling of euphoria. Dr. Wells, ever the keen observer, noted that a gentleman injured himself at one such event but did not seem to feel any pain. Perhaps the nitrous oxide would also work for dentistry!

Soon after, Dr. Wells tested the theory himself, taking a deep breath of the magical gas before an assistant removed one of his teeth. (Presumably there was something wrong with the tooth and it needed to be removed). He felt no pain! Dr. Wells began using nitrous oxide in his practice and eventually lined up a demonstration with the medical establishment in Boston.

The demonstration did not go well – the patient cried out in pain during the procedure. The audience severely boo-ed Dr. Wells, discrediting him in the medical community. To make matters worse, one of his students stole his spotlight, later gaining international fame for using ether as an inhaled anesthetic. Although he briefly continued to use nitrous oxide after returning to Hartford, Dr. Wells gave up his practice and became a traveling salesman. He ended up going to Europe on behalf of a former partner to promote the use of anesthesia.

After returning to the States, Dr. Wells decided to experiment on himself again. This time he was interested in understanding the effects of chloroform. He became increasingly deranged and in a fit rage ran into the street and threw sulfuric acid onto the clothes of two prostitutes in New York City. He was arrested and sent to the infamous Tombs Prison. As the effect of the drug wore off he realized what he had done and committed suicide in his cell.

Dr. Wells was later proven correct in his use of nitrous oxide, which is still in use today. In 1864 he was recognized by the American Dental Association as the discoverer of anesthesia. The Bushnell Park statue was commissioned in 1874 by a collection of dental and municipal organizations.

So that’s the story of Dr. Horace Wells – thank you for your contribution to dentistry, good sir!

Home Equity Lines – They're Alive!

Who says there is no money out there to borrow against home equity?

After doing a little business with Bank of America in downtown Hartford the other day I was surprised to see a big sign in their lobby announcing Home Equity Lines with rates of 4.24% for \$50,000 and \$100,000 lines. The gentleman at the info desk assured me that not only was it still possible to get a home equity line, but that Bank of America has been offering them without interruption! I was not allowed to take a picture of the sign as proof, but I swear it exists. A quick search of the World Wide Web confirms that Bank of America is in the game, and shows that other lenders are also advertising home equity lines on their websites.

Home equity lines played a big role in our current financial crisis. Although they can serve a variety of purposes, many homeowners bet that home prices would continue to rise and used their line to extract all of the equity from their property. The cash in hand was spent on anything from home improvements to retiring more expensive debt to discretionary purchases with no enduring value. All the anecdotal evidence that I had seen suggested that banks either froze or cancelled outstanding home equity lines in an effort to manage the risk to their firm’s capital. The resulting reduction of available credit has been an inconvenience to some, and has actually hurt the credit score of others.

According to a local mortgage broker, home equity lines never completely went away. Instead the lenders simply became more conservative. They definitely froze and cancelled some lines, but at the same time they were still willing to extend new lines to very well qualified borrowers. If you had low loan-to-value ratios and good credit you have always been able to get a line. Lenders have also been changing their pricing. Where before they would offer a discount to Prime with no minimum rate, they are now charging a premium above Prime with a minimum interest rate of 4%. Finally, borrowers need to look carefully at the overall cost of a home equity line since very few people qualify for the advertised rates. Most borrowers end up paying additional points, fees, and/or expenses that increase the effective interest rate, or APR, of the line.

So it seems that the major financial institutions are still willing to add some risk to their portfolios. And we know that the government wants them to be lending despite being forced to provide considerable assistance to keep the institutions solvent. The underlying economic theory is the multiplier effect, which tries to quantify the overall impact of an additional dollar. In this case, each dollar that is loaned is spent and re-spent a number of times, spurring growth in the overall economy.

My conclusion after all of this is that although home equity lines are advertised as available, they might not be available to you. And even if you do qualify, the line may be more expensive than expected. As always, be careful when borrowing…