My Personal Finance Journey

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My (Upcoming) Refinancing Deal In Microscope

Contributed by mm | April 3, 2004 8:15 PM PST

I blogged on March 30 that I submited a refinancing application for a 5/1 ARM loan at 3.50%. The loan was approved online but I couldn't connect to my loan office for two days. I was finally able to confirm the rate and receive the loan package in paper.

Without a question, the 3.50% rate for 5/1 ARM is a fantastic rate. I had been tracking the 5/1 ARM since mid March via BankRate, and the rate only appeared for one day or two and only from EverBank while most of the other banks are offering 3.75% at best. With the blowout employment numbers released yesterday morning, and the huge runup of all treasury rates (5-year treasury went up by 28 basis points and 10-year treasury by 24 basis points), I highly doubt we will be able to see this rate again in a decade. As a matter of fact, I am checking what EverBank is offering at the time of writing, and EverBank effectively froze the program by offering 5/1 ARM only at 3.75% rate with 1.125% points.

Here is some more information released in the loan package:

First, this 5/1 ARM has a cap of 5/2/5, which means 1) after the initial five-year period, the rate can climb to as high as 3.50% + 5.00% = 8.50%, 2) every year thereafter, the rate can climb 2 precentage point above last year's rate, and 3) the life-time cap of the loan is 3.50% + 5.00% = 8.50%

Second, the rate is determined by applying a 2.25% margin on top of one-year LIBOR rate, rounded to the nearest one-eighth of one percentage point. (The one-year LIBOR rate at the time of my rate lock was 1.3410%, so the computed rate should be 1.3410% + 2.2500% = 3.5910%, so apparently the initial rate is kind of a teaser rate. I will be paying 3.625% rate after 5 years if the LIBOR rate keeps flat.) After the employment number, the 1-year LIBOR rate is standing at 1.37% the last time I check.

Third, according to the disclosure, EverBank is highly likely to keep the loan in its own book instead of securitizing it and selling to the market. Apparently, my 3.50% 5/1 ARM, if closed, will be a loss for the bank, so I do have some concerns as of whether the bank will be make all efforts to close this refinancing in the 30-day rate lock.

Fourth, the closing cost is likely to be $1,800 as presented in the Good Faith Estimate. EverBank offers an incentive of $100 for me to return the signed paperworks in 10 days (which I will surely do), so the closing cost will be lower than I originally quoted. I understand Good Faith Estimate is not binding, but I feel it should be pretty close to the final due for a large company like EverBank.

I spent some time to formulating a model to understand the exact benefit of the refinancing. My methodology is:

1) Model the monthly payment (principal and interest) in my current 7-year Balloon at 4.25% and that in the 5.1 ARM at 3.50%

2) The different in the interest is the money I can save by refinancing (note the 5/1 ARM will put more monthly payment to principal so it is unfair to compare just the monthly P+I payment -- the monthly P+I payment difference is around $120 while the interest difference is around $155 in the initial few months)

3) The real saving, however, should be after tax. Because the mortgage interest is generally tax deductible, if I save $155 in interest payment in the first month, I can only save $116.25 at a tax bracket of 25%.

4) I then calculated the Annualized Rate of Return (ARR) of the deal if I stay in the house for X number of years, given an initial cash outlay of $1,900 for closing cost. The result is:

If I stay for one year, ARR = -42% (yes it is negative -- it takes almost 1.5 years to recover the closing cost)
For two years, ARR = 47%;
For three years, ARR = 80%;
For four years, ARR = 93%;
For five years, ARR = 98%.

5) I also calculated the Net Present Value (NPV) of the deal with a discount rate of 10% (which is a bit higher than my expectation of Total Return on Investable Cash). The result:

For one year, NPV = -$577
For two years, NPV = $608
For three years, NPV = $1,670
For four years, NPV = $2,619
For five years, NPV = $3,467

As my family is fully committed to staying in the house for at least 2-3 years from now, I see all the upside of the refinancing. This refinancing represents a tremendous return to the $1,900 closing cost with ARR easily topping 100% in my expectation. (I'll literally kill if I can find other 100% ARR opportunities in my personal finance management. :-) )

I am, however, aware of some potential downside of the deal:

First, if the rate establishes another decade-low, I may be worse off doing this refinancing instead of staying put. I seriously doubt it will happen though.

Second, my current 7-year balloon provides 1.5 years more rate assurance than the 5/1 ARM, so if I live in the current house beyond the 5-year period, and if there is a rate hike, I might be worse off putting myself into this 5/1 ARM deal. But on the other hand, if the rate five years from now is too high, the 5/1 ARM will still protect me somewhat because of the multiple caps. The 7-year Balloon may provide 1.5 years more rate assurance, but after that I will have tremendous risk if the prevailing rate is unbearable. In addition, by year 2009, I expect my net worth will be in the north of $300,000, so I might seek a better home before that anyway.

I'm fully hearted to put all efforts to close this deal within the 30-days rate lock by April 30. I hope I am as luck as possible: closing this deal will amount to a huge saving in the next few years!

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