BY GREG MERMEL, CPA
This looks to be a poor Christmas selling season for retailers. Television
and newspapers quote various expert opinions about the cause: the recession,
post-September 11 funk, the weather is too warm and dry, the weather is
too cold and snowy or the invidious influence of Martha Stewart.
Since I know at least as much as some of these talking heads, I am offering my own opinion. If my clients are typical, everyone is too busy refinancing their home mortgages. And if you’re not, maybe you ought to be.
Up and Down
For quite some time now, the Federal Reserve Bank lowering interest rates has been a recurring news story, so much so that just about everyone who has, or potentially could have, credit has gotten the message that rates are low. But the Fed actually controls only one interest rate, for very short-term loans from it to banks. Not all interest rates in the U.S. economy move in lockstep. Credit card rates, for example, have not dropped as much as the Fed’s rate, for two likely reasons. One of them, yes, is pure greed, but card issuers also want a cushion for the increase in uncollectible accounts which accompanies a softening economy.
Classic supply-and-demand economic analysis says that if the price of "x" drops, demand for "x" will increase. That happened with mortgage interest rates through the summer. Whenever the Fed rate dropped, so did mortgage rates, and more people found refinancing made economic sense. Enough people started refinancing that lenders began to have trouble handling the business. So they did what classic supply-and-demand analysis says they would: If supply is short, one rations demand by raising the price, i.e., the interest rate. (Unusually, what’s in short supply is loan processing capacity rather than money to lend.)
You might expect rising interest rates to cut the demand for mortgage refinancing, but instead the demand increased. People who were waiting for rates to go still lower saw the increase and changed their minds. "Act now," they thought, "before rates increase more." In supply-and-demand analysis terms, the demand curve shifted, probably enough to register on the Richter scale. Lending officers are busier than ever.
I’d Rather Be Out Caroling
If you were expecting me to offer a simple formula to figure out whether refinancing is worth your while, well, you just got a lump of coal in your Christmas stocking. There are just too many factors, and some of them are too subjective to quantify. Refinancing requires a good bit of your time, both shopping for deals and following through from application to closing. What is your time worth, and how good is your tolerance for the hassles that go with the process?
Even those items which can be reduced to numbers require a certain subjective evaluation. Refinancing will reduce your monthly payment, but a typical residential refinancing in the Chicago area costs $1,200 to $1,500 if you pay no points. How many months will it take to recover that cost? If the answer is six, almost anybody will refinance; if the answer is 60, almost nobody. Between those extremes, when does it become "too long"? Twelve? Eighteen? Thirty-Six?
"Points" complicate the analysis. A point, as you may know, is one percent of the loan amount, paid to the lender as an up-front fee in exchange for a lower nominal interest rate. In reality, paying one point means that a nominally $200,000 loan is really only $198,000. Since the interest is figured on the higher amount, the effective interest rate is higher than the nominal rate. How much higher is another "it depends." Most lenders will be happy to calculate the effective rate for you—indeed, it is a required disclosure—but the calculation is only valid if the loan is paid in regular payments over its entire term.
Here is a question for you: Do you know anyone who has paid off a 30 year mortgage by making monthly payments for 30 years? I know five, and I am privy to several hundred people’s financial information. The average actual duration of a home mortgage in the U.S. is about seven years: People refinance (perhaps because rates have dropped, or because they want money to fix up the place) or sell their homes and move. Amortizing the point over a five- or seven-year period will produce a significantly higher interest rate than doing it over a thirty-year term.
If you do not want to tackle the higher mathematics needed to calculate the effective interest rate (and I am pretty sure you don’t), just do a payback period calculation for the points, just as I did for refinancing costs.
Shopping You Can’t Do At Target
You will find all sorts of mortgage lenders out there. If you are considering refinancing, always start by inquiring with your existing lender. You have a history with them (presumably a good one) and often they can do a refinancing "in place" with lower closing costs. Talk to your bank as well.
Otherwise, mortgage financing is done through three types of businesses: banks, mortgage bankers, and mortgage brokers. Banks and mortgage bankers make their own credit decisions and fund the loans themselves, though they may be quickly sold off to another lender. Mortgage brokers, in contrast, shop your deal around among numerous lenders. This is a mixed blessing. Your hassle factor will go up, because each lender will want different documentation. While a good broker can find you a deal you never would have located, a mediocre one won’t. And despite licensing rules, there are some charlatans. Add the difficulty some have dealing with borrowers whose income is less predictable than a civil servant’s, and I would not use a mortgage broker who did not come with strong recommendations from your friends, realtor, attorney or accountant.
Are there money or
tax questions you would like to see discussed in this column? Let me know,
at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or 773/525-1778 (888/525-1778
outside the Chicago area).
Greg Mermel is a certified public accountant whose clients in the arts
range from individual performers to major theatre companies and suppliers.
He also sometimes produces theatre.