The Lowest Rate is not Always the Best Idea
While the process for doing a VA IRRRL was laid out in a previous post, today we are discussing a very specific and extremely important aspect of your refinance: How to Structure a VA IRRRL.
When I say "structure", here is what I mean: what mix of rate, fees or credits, loan amount, funding fee financing, and equity is right for you? What future circumstances do you need to consider?
Be honest....if you haven't been following our blog, you probably didn't even know you needed to think about all of this, right? The rate is the rate, and if it's lower than what you've got, you're going to refinance, pay fees, and be better off, right?
At this point, I've written quite a bit about the relationship between the interest rate and the closing costs of a potential new loan. Why harp on it? Because it's critical to understand, that's why. If you don't get it, you'll likely make the wrong decision. Like so many parts of life, making the wrong decision when it comes to your VA Loan will cost you money. I'm going to take you through the steps to make the right choice in structuring your VA IRRRL.
Closing Costs and Interest Rates
The closing costs for a VA IRRRL vary greatly from transaction to transaction. It depends on the lender, state the property is located, value of the home, and whether or not you have a service-related disability. Some states have refinance related taxes, most don't. Some counties have transfer taxes, some don't. Some lenders charge fees, some require appraisals, and some do neither. In addition, a lender can charge you a percentage based fee associated with a given rate (points), or give you a percentage based credit for taking a higher rate, which is the opposite of points (or negative points). This will either be labeled as a Discount Point, Origination Fee, or Lender Credit (in the case of negative points).
For example, Lender ABC may be offering you a rate of 3.25% with 0.5 Points and a 1% Origination. Lender XYZ comes along and offers you 3.375% with -0.5 points and no Origination Fee. Which one should you choose?
We see very similar scenarios quite often, and it always surprises me how many people make the wrong choice. The lower rate is shiny and people are drawn to it like flies to a bug zapper. Now, normally I would say that the right choice depends on your goals, and that would be absolutely true. However, I'm going to use this example to highlight two points.
- We are going to compare the breakeven timeframes between the two offers, and compare that timeframe to your own plans.
- I'm going to tell you what to do about each lender.
Straight up, the difference between the two lenders is 0.125% in rate and 2.00% of your loan amount in cost. The dollars associated with these percentages will obviously change dramatically with different loan amounts. In order to illustrate what the difference could be, I'm going to use a very average loan amount of $300,000.
Funny thing is this, if you're sitting in Washington D.C. you think I'm crazy for choosing such a low average. If you're sitting in El Paso, TX, you think I'm crazy for choosing such a high average. It's a big country, with lots of variance, so please bear with me. (For the record, I'm only like a "4" on the crazy scale.)
Below, in true VAFinances fashion, you're going to find a chart. Yes, we use charts a lot. Yes, there's a reason. It's an easy way to illustrate, side by side, the differences between two options. I always hated the word problems in math class, so when it comes to numbers, I prefer to show vs. tell.
Chart Assumption for This Example: $300,000 VA Loan for a client that lives in a state that does not charge state mortgage taxes. Client has a 3.75% rate currently and is exempt from the VA Funding Fee due to a service related disability. All rates represented are for example purposes only; there's no way to predict when you will read this and what rates will be at that time. However, the underlying principals will stay relevant.
It should be crystal clear IMMEDIATELY which of these two options you should choose. Normally, as I mentioned, it would depend on your future goals because the discrepancy in the offers would not be so drastic. However, we've been seeing this more and more lately as some lenders look to increase profits on the last refinances in what many expect to be an ending era.
Not following? Let me direct you to one critical line, the Breakeven Months. This number is telling you how long it will take you to recoup your initial cost by receiving your monthly savings. In the case of Lender ABC, the cost is high, an even though the monthly savings is a little bit better, it is taking 68 months (almost 6 years) to pay yourself back for all the money you're rolling into the loan or paying out of pocket. For Lender XYZ, not only are you saving $63 monthly, but the Lender Credit is higher than the Fees, so the Total Cost is negative. This means you are making money up front. There is no breakeven because you start ahead of the game right out of the gate. If you choose ABC over XYZ, the final number in the chart tell you it takes you 290 months to benefit from that choice. That's too long no matter who you are, in my opinion. If this number was around 6-36 months, it would be worth a discussion. However, with the uncertainty of the future, and how often people move or refinance, anything longer than that should be approached with great caution.
NOTE: Remember to ignore anything unrelated to lender control when comparing lenders. Your property taxes and home insurance are irrelevant; you pay those no matter what. Title fees are determined by a 3rd party, and you can shop for those independently of your lender if you choose.
Can't Get Over That Lower Rate? Than Do THIS:
I get it. You just want to get the lowest rate you can because you are going to be holding this property forever and you never want to have to worry about refinancing again. It's a valid point. Here's what you need to understand about what's likely going on behind the scenes. Lender ABC is showing you their lowest rate possible because they know most people only look at that and they want to win your business. You're looking for the lowest rate, and they're raising their hand saying "yep, it's over here!". Lender XYZ is showing you the deal that makes most sense for you. They probably have lower rates available, but your Loan Officer has done his homework, realized that's not the most financially savvy choice, and presented the alternative "low-cost" option. So why not go back to them and say, "thank you, but I'm willing to pay more to get a lower rate, so what would be your cost structure at 3.25%?" We don't hear enough of this, because people don't realize that's how it works. Look, remember above I said there was a 2.00% difference in points between the offers? Well, that is a BIG difference. So, if XYZ can offer you 3.25% with a, let's say for example, 0.25% charge instead of their Lender Credit, that's a 1% jump in cost from their first offer, but still 1.25% BETTER than Lender ABC! Do your due diligence, and ask the right questions, it pays off.
Should I Roll in the Cost, or Pay it Out of Pocket?
I'm telling you that you should have the Lender pay most of the cost for you, to the extent it's possible. However, there is often items leftover that need to be dealt with, like establishing a new escrow account, paying the VA Funding Fee if you're not exempt, or any remaining costs left after lender credits. I'll make this simple: in today's historically low rate environment, just roll it into the loan. You may never again find the ability to take a loan out and pay so little in interest, so take advantage. It makes miniscule differences in your payment, and in my opinion, cash is still king, so hang onto yours. Here is the one exception: some lenders require an appraisal or AVM (electronic appraisal) on an IRRRL, and some investors have pricing adjustors for being over or under certain 5% thresholds of your loan to value (LTV). Meaning, you may get a little discount for being at 99.9% LTV instead of at 100.1% LTV because you've crossed the 100% threshold. Makes sense? The same may hold true for crossing 95%, or 90%, etc. So a very valuable insider tip is this, if you are near one of those 5%thresholds (i.e. right near 85%, 90%, 95%, 100%, 105%, etc.) then ask your Loan Officer if they require any sort of appraisal. If they do, ask what the cost/benefit of paying your loan down vs. rolling in cost may be.
How to Account for the Future
We keep talking about these 'future goals' and that they can affect your decisions now, so let's dive deeper on what that could mean.
How Long are You Going to Keep This House?
Ok, this one is obvious, right? Maybe, but it has some non-obvious implications and sub-questions. I've heard people say that they shouldn't bother to refinance because they 'eventually' plan to sell their home. That doesn't make sense. Be more specific with your plans and the likelihood things go as planned. Depending on your rate and the offer you can find, it may make sense to go through refinancing if you plan on holding the property for as little as 6 months if you are making money instead of paying money up front, like with XYZ in the above example. On the other hand, it may not be worth it at all, ever, if your rate is low enough that you can't find better. Those are the extremes, so at least find out where in between you fall. IRRRL's are unique in their relative simplicity and higher allowable loan to value ratios, and to the extent you can take advantage of that to save money, you should.
Also, acknowledge that "keep this house" is different from "live in this house". Is being a landlord part of your long term financial plan? It would make sense, if you can handle the risk. If it scares the heck out of you, it may not be worth it. However, your VA Loan may not have required a down payment, so what if you can't sell it for what you owe...what's going to give? In most cases, setting yourself up for a lower payment will help, and then you have to decide whether to use the cash savings to build an emergency fund or pay down your loan.
What's Your Rate Outlook for the Future?
We have clients that have refinanced 4 times in the last 3 years and never paid a dime for it themselves. Each time, they took the 2nd or 3rd lowest rate instead of the lowest rate available because it had enough Lender Credits to pay for the transaction and sometimes even cause them to make money. Pretty savvy, as the market kept going lower and they got to keep taking advantage. At any point, if they had chosen to pay more fees or points for an artificially lower rate, it would have cost them not only on that transaction, but would have negated the subsequent transaction, thereby costing them twice. On the flip side, if rates had shot up, they would have been stuck with "not the lowest rate in history" albeit a lower rate than they initially had. Decide for yourself which risk you feel is better to take. Personally, I don't' see how rates can go much lower than this. However, I've said that many times before and been wrong each time (come on, they can't keep going down forever, it's impossible, right?!!?).
What About the NEXT House?
This one is pretty "next level", but I'm throwing it out there because it happens. In most cases, Veterans take a long time to build equity because they put very little (or nothing) down when they buy. So, when they go to buy the next house they have to figure out how much Entitlement they have left to use if they aren't selling their current VA secured home (yes, you can do that). But what if you've had that home awhile, and there's equity built up? What if then you were looking at buying a new home using a VA Loan, and though you have equity, you don't have cash? Well, instead of doing an IRRRL in that case, you might consider doing a Conventional refinance to free up that Entitlement for the new home.
As you can see, there is quite a bit more to consider than just the interest rate. Hopefully, I made that abundantly clear. After all, that's what we are here for--to take complicated financial situations and make them easier to digest for Military families, and to give insight you won't find in your typical high-level blog. Want more? Subscribe to the newsletter, and follow along with our journey through the financial world.