Serial refinancing or surreal financing

REFINANCING TO THE RESCUE!!!! First off, I want to say thanks to 'Harm' for suggesting the title for today's post. There was an interesting discussion going on at Ben's blog about this article that made the 'bold' statement that Interest Only Loans Prove Short Term Fix. The article investigates situations where borrowers refinance one interest-only (I/O) loan for another when the interest only period stops.

It seems that people were amazed by this fact. What do you think people are going to do after 2, 3, or 5 years of a nice low fixed payment?!?!? There appreared to be some sighs of despair as people thought "oh no, this thing is never going to end if people can keep refi'ing into another I/O loan". Well, don't you worry. There are quite a few obsticles in the way of simply refinaning again to another I/O ARM.

Let's look at some quick math before we get ahead of ourselves...that is why you come here right??

Note: I'm looking at several rate sheets and using rates that are typical of what is being seen in the market. Whether a borrower is A-paper or subprime, the spread between the rates is similar...so just bear with me.

Let's take a $300,000 loan at 5.25% I/O ARM (you can use 2, 3, 5, 7, 10 year I/O period...doesn't matter in this case)

Payments for x-amount of months = (300,000 x .0525) / 12 = $ 1,312.50 a month

Now lets look at those payments when they adjust. Not only do the payments adjust, but you have to start paying the PRINCIPAL off as well (unless you refi/sell/foreclose). Let's say the rate jumps to 6.75% (could be higher, but most have a 1.5% cap on each adjustment) and NOW you have to amortize over the next 28/27/25/23/20 years because you didn't pay any principal during the initial I/O period. So.....

Payment when the 2yr ARM adjusts = $ 1,989.68 a month . . . . .payment JUMPS $677.18 in one month!
Payment when the 3yr ARM adjusts = $ 2,014.80 a month . . . . .payment JUMPS $702.30 in one month!
Payment when the 5yr ARM adjusts = $ 2,072.73 a month . . . . .payment JUMPS $759.23 in one month!
Payment when the 7yr ARM adjusts = $ 2,143.24 a month . . . . .payment JUMPS $829.74 in one month!
Payment when the 10yr ARM adjusts = $ 2,281.09 a month . . . .payment JUMPS $967.53 in one month!

Let's also remember that I'm not even crunching the numbers of how much extra money will be paid in interest over the various periods. That would get really ugly, and besides, most people won't keep these loans that long, or stay with the property that long.

Ok, that's nice SoCalMtgGuy, but these people are going to refi before the adjustment hits. Oh that's right. Before they can refi, they will need a few things:

They will need to have some equity if they plan on refinaning the way they have been the past few years. I'm going to assume they didn't put very much, if any, money down. To show that they have equity, they will need an appraisal. I know there has been talk of appraisers pushing value. It is "easier" to do that in a market that is trending upwards. If the comps are falling, it is very hard to push the value on an appraisal. Some of you are asking why they need some equity to refi. Nobody works in this business for free...not the broker, not the title company, not the lender, and not the escrow company. All of those people want, and need to get paid for their services. So unless this borrower (which can't afford a higher monthly payment) has several thousand in savings to pay the fees, they will need to use the equity to pay for the refinance.

Let's look at some scenarios that might hurt people's ability to refi into another I/O loan:

- property values decline, and they are upside down. They can't refi without coming to the table with money...and if/when they do refi, they will be at such a high rate because of the LTV and higher rates that they won't be able to afford that either.

- lenders have this thing called benefit to the borrower. My lender will not refi an ARM into another ARM until it is adjusting or unless they are lowering payments a few hundred dollars per month or they are taking out enough cash to be at least 2x the cost of the refi. Even if the loan is adjusting, there can be times when there isn't a benefit to spend thousands of dollars to refi to save a few hundred.

- the borrowers that had lower LTV's will be at higher LTV's if prices decline. Higher LTV's will mean higher rates, and harder times for the borrowers.

- all of this assumes the borrower didn't take on extra debt, or have any credit problems. It seems that many people like to buy furniture/stereo/other goods on credit when they buy a new home. That is all well and good...but if you can't pay for those things in a timely manner, it WILL ding your credit score, and that will affect the rate you can get when you look to refi again.

But let's get back to our scenario, and assume that our borrower can get a 7.25% I/O loan on $300,000 and let's assume they paid cash for the refinance.

So, the new Interest Only loan payment is: $1,812.50 . . . . or a payment jump of $500.00 after refinancing.

The best case scenario for this borrower is to have enough equity so that they can refinance. Notice that I was kind, and did not add the cost of the refinance to the 300k loan balance. If I did that, the payments would be even higher.

Now that we have looked at the math, let me tell you what I see in the real world. In the industry, we call these people "refi junkies". These are the people who habitually refinance as many as 2-3 times in a year. I remember one credit report where the borrower went from a 360k loan, to a 430k loan, to a 500k loan, to a 565k loan, to a 635k loan, and this was going to be "their last refi...promise" at 710k. That would make 6 refinances in about a 4 year time period. But THIS time they were really going to pay off all their debt and not get into more debt. If you just assume the standard 6 months interest that is charged as a pre-pay penalty, these borrowers wasted a good 60-80k in pre-pay penalties as they jumped from loan to loan. I couldn't do that loan. Their LTV was too high, debt level too high, loan amount too high, and credit score too low to do a loan that would make sense for these borrowers. I do know that they ended up getting a loan after much trouble...but I have no idea if they really changed their ways or not.

Many of you reading this blog are probably scratching your heads in amazement. I have touched on it before, and I will touch again on HOW many of these ARM's are sold. The brokers sell the loan like this: "just get in the market. Get a low payment now, and when it adjusts, you will have equity, so just refinance into another ARM". It is stated so plainly that property will appreciate and refinancing will "automatically" bring lower payments like it has the past 5 years. The broker get an "annuity" from people coming back to them every 2-3 years to refinance. Would you rather make a few grand from the same person every 2-3 years, or would you rather put them in a fixed rate loan where they won't be back for a while?!? There are lots of good brokers that are professionals and will recommend what is best for the borrower, not their own personal pocketbook. There are also lots of brokers that love to churn the loans and make the easy money. A home purchase/refi is a big financial decision. It isn't something you just jump head first into with some broker over the phone. There better be some homework done before you make a financial decision with hundreds of thousands of dollars.

Just take what you learn here, crunch the numbers, and make a decision for yourself. Don't be afraid to ask questions you already know the answer to. This way you will find out if they have integrity and/or are just an idiot. Either way, you won't want to deal with them.

All and all, on paper it looks like there is going to be a massive refi-boom coming again in 2007 for sure. The problem is that many of those borrowers don't intent to refi, they intend to sell. They knew they couldn't make those payment for more than the introductory time period...but they wanted to make the money on appreciation, and then cash out. Even if only 15-20% of the people had that idea, that is still a ton of inventory that will be dumped on the market. Nobody knows for sure what will happen...as there is no precedent for the way money has been lent out these past few years.

On a side note, I made some changes to the blog over the past few days. I made the format wider, and hopefully easier to read. At the request of several people who have been reading this blog for a while and who I have been helping over e-mail, I added a 'donate' button. Thank you very much to those of you that have donated! I really appreciate it. It takes a lot of time to write the posts and reply to each of the hundreds of e-mails I have received. No pressure at all (I mean it!)...but it's there if you want to use it.

Keep the comments and feedback coming!!!

SoCalMtgGuy