Who Gets to Refinance In a Stressed Market?

February 2, 2009, Revised February 23, 2009, April 27, 2009, August 17, 2009

It is unusual to have a refinance boom in the middle of a foreclosure crisis. In the 1930s, which was the last time we had a foreclosure crisis comparable in magnitude to this one, lenders were so spooked by the foreclosures that there was almost no refinancing. That changed only after the creation of the Home Owners Loan Corporation (HOLC) in 1933, which refinanced many borrowers at the Government’s risk.

The refinance boom today is also fueled by Government. With few exceptions, refinanced loans are either being sold to Fannie Mae or Freddie Mac, or insured by FHA. The requirements of those agencies largely dictate who can and who cannot profit from a refinance.

The refinance decision involves a comparison of what a borrower has with what he can get. If he is currently paying 5% and can refinance at 4.5% and no fees, he will profit from the refinance. If he is currently paying 7% but the best he can get in the current market is 7.5%, he can’t.

Borrowers with fixed-rate mortgages (FRMs) usually know what they have, but borrowers with adjustable rate mortgages (ARMs) often don’t. I have received letters from borrowers in a state of high anxiety because their ARM faced a rate reset and they felt they had to refinance before that happened. In some such cases, a close look revealed that their rate was probably going to drop sharply, making it unnecessary to refinance quickly -- if ever.

Readers who ask me whether they should refinance usually tell me what they have but seldom tell me what they can get. They expect me to know that, but I don’t because it depends on so many factors specific to them that they haven’t told me about.

Borrowers in the best position to refinance profitably have loan balances of $417,000 or less secured by a single-family house in which they reside, have a credit score above 740, and have equity in their property of 20% or more. The interest rate premiums associated with deviations from this standard are larger today than I have ever seen them.

Note: The premiums reported below are those being quoted by some large wholesale lenders on 30-year FRMs, and are reflected in the retail rates quoted by many mortgage brokers and mortgage banks. The wholesale market is not as competitive as it was before the crisis, however, and I can't guarantee that the lenders for whom I have data are fully representative. Furthermore, their prices may not apply to smaller credit unions or community banks.

Borrowers with loan balances above $417,000 up to $625,500, who live in higher-cost areas where Fannie and Freddie are authorized to buy loans up to $625,500, will pay a price premium that varies widely but can be as large as 1% in rate. These are “conforming jumbo”, meaning that they can be purchased by the agencies but are priced higher than non-jumbos.

Borrowers with balances in excess of $417,000 who do not live in a high-cost area, or who have balances in excess of $625,500, will pay a premium closer to 2%. These are “non-conforming jumbos” that cannot be purchased by the agencies.

On loans secured by condominiums, figure on paying a rate premium as large as .75%, and on 2-4-family homes, the premium can be twice that large. If a loan is secured by an investment property, figure on paying a rate premium of about 1.375%. Those refinancing who borrow more than their loan balance will pay a premium of about .25%. However, they can finance settlement costs without it being considered “cash-out.”

Shortfalls from excellent credit have become very expensive. Most lenders use a credit score of 740 as their cutoff, below which they charge a rate premium, but some use 780. The premium on a score of 700 can be a high as 1.125%, and on a score of 600 it can be a prohibitive 2.625%.

If a borrower has equity of less than 20% -- meaning that the loan balance exceeds 80% of current property value – he will pay a mortgage insurance premium. This can make refinance a loser for borrowers whose recently purchased homes have declined in value. For example, if Jones borrowed $160,000 to purchase a home for $200,000 in 2005, still owes $158,000 and the house is now worth only $180,000, a refinance will require mortgage insurance where the original loan did not. If the house is worth only $150,000, the loan can’t be refinanced at any price.

On loans that will be sold to Fannie and Freddie, increased risk premiums have been accompanied by tougher approval standards. In particular, documentation of income, which had grown lax and sloppy during the go-go years, is now rigorously enforced. Approval is also dependent on a satisfactory combination of all the risk factors discussed above. For example, a FICO of 650 might be approvable if all other factors are favorable, but a 650 score on an investment property with only 5% equity will be rejected.

Loans that won’t be approved by the agencies might past muster with FHA, whose requirements are more liberal. But FHA loans carry higher rates and insurance premiums. See FHA Mortgages: A 2009 Update.

Under a new Federal program called Making Home Affordable, which was introduced after the first version of this article was written, qualified borrowers whose loans are held or guaranteed by Fannie Mae or Freddie Mac can refinance without paying for mortgage insurance even if the loan balance is as much as 5% (later raised to 25%) higher than the property value. See The Administration's Plan to Assist Mortgage Borrowers.