As it turns out, most refinances of loans below $100,000 don’t make a lot of sense in the end. Here is why: There are fixed costs associated with a refinance and those fixed costs are the same for a small loan as they are for a big loan. See this page for more on the costs associated with refinances.
So for example, let’s consider a loan of $100,000 at a 6.75% interest rate. The borrower hears that rates have dropped to the low 5’s and assumes that a refinance is a no-brainer. But let’s take a look at the numbers. Here are the fixed costs:
Bank fees and appraisal — ~$1400 (assuming no points)
Title and escrow fees — ~1000 (depends on the state)
FHA upfront insurance fee — $1750 (1.75%)
Tax and insurance prepayments — ~$1200 (This is not actually a fee, but it does roll into the loan anyway)
So in this scenario the borrower ends up with a new loan of $105,350. Now some of that is offset because the borrower skips a month of mortgage payment and the old escrow account (assuming one is in place) is refunded, but even so the actual costs are probably around $4000. None of that is out of pocket but the costs are still real.
Now here is the problem. Even if the new rate is at 5.0% the payments on the FHA loan would probably only be about $40 less per month when we factor in the FHA monthly mortgage insurance. That means the borrower will save about $500 per year. And that means that it would be at least 8 years before that borrower broke even on the costs associated with the refinance. Of course if the borrower plans to never sell the house such a refinance makes a lot of sense because $500 per year is very helpful. But if the borrower might sell the house in a few years the refinance makes less sense.
So the takeaway is that for smaller loan to make sense normally one or more of the following must be true:
1. The current interest rate is very high (at least mid 7s or higher)
2. The borrower does not plan to sell the house for several years
3. The borrower needs cash out to pay down other high interest rate debts
For instance, if the original loan in our scenario above were at 8% (instead of 6.75%) then the savings on the refinance would be more than $120 per month. With those kinds of savings the refinance starts to make a lot more sense.
The good news is that for larger loans the fixed costs are much less of an issue and the numbers usually work out quite well.
Please contact us if you have any questions about this subject.