I have helped many clients refinance and there a question that comes up over and over again... it is, "why is my balance going up so much?" In this article I will address where all the money goes and give some insight as to why your loan balance goes up when refinancing. Let's get started...
The increase to your loan is not the cost to refinance!
First off, the delta between your new loan and your current loan balance is not your cost to refinance. It would be nice if the math was that simple, but the increase of your loan balance is not your cost to refinance. There are 3 main components that get you from your current mortgage balance to the loan amount your lender is showing on the documents.
3 components of your NEW loan amount
There are 3 main reasons your balance goes up when refinancing. They are closing costs, pre-paid items, and the loan payoff. Let's break each of these down.
(#1) Closing Costs
These are the actual "costs" of refinancing. The other items (prepaids and loan payoff) are not costs to refinance. To further confuse you, there is a line item on your LE (Loan Estimate) that will show your "closing costs" being some massive number. It’s probably a much larger number that you were expecting and can make refinancing appear less “worth it”. The majority of that big number aren't costs. The LE does a pretty poor job explaining this. It’s notated in super-small italics that your closing costs are (loan fees, plus other fees, minus lender credits). The “other fees” are especially confusing, so let me break it down for you more clearly.
The true "costs" of your loan are the following:
* Lender 3rd party fees (Eg: appraisal and credit report fees).
* PLUS: Any points, origination fees, FHA or VA funding fee.
* PLUS: Title fees.
* PLUS: State/County recording fees.
* MINUS lender credits.
These costs are the first component added to your financed amount. As I mentioned earlier, everything else added is not a cost, but rather something you already owe.
(#2) Pre-Paid Items
Pre-paid items, otherwise known as "prepaids" or the “other fees” as referenced on your LE. These are items you will owe as a home owner. Your lender will collect in advance on the new loan and pay them for you out of your escrow account. The prepaids are broken down into Prepaid Interest and Escrows.
- Prepaid interest is the amount of interest you will pay on the new loan from the date you close to the end of month. Since you "skip a month" when refinancing, your lender collects the remaining interest due through the remainder of the month that you close and builds that into the loan. For example, if you closed on 4/10/2020, your loan would fund on 4/15/2020 (this is because of the 3-day right of recision). The lender would collect prepaid interest for 16 days and then start accruing interest that will be paid with the first mortgage payment on June 1. Interest accrues in arrears on a loan so even though you are skipping a payment, it's not free. :)
It is possible to have negative prepaid interest. This is when you close early in the month and the lender credits you those days that you will pay with your next mortgage payment. The kicker is that your mortgage payment starts a month earlier. So, for example if I closed on 4/2/2020, the lender would give me a credit for 2 days of interest and my first mortgage payment would be 5/1/2020. As you can see, it's a pay now or pay later sort of thing. Personally, if you can pay later on, I'd do it that way.
- Escrows are charges to set up your escrow account for your new loan. The lender will collect enough money up front to ensure they can pay your tax bill and insurance bill when they come due. In most counties, the payments for taxes are taken 2x per year so the lender will make sure that when it's time to pay the tax man you have 6 months plus 2 months of reserves in your escrow account. Since you "skip" a payment when refinancing (see above) the lender factors that in to how much they collect. The same is for insurance which is billed once a year. When refinancing you have to have a full year plus 2 months when the bill is due. When your lender does this analysis it is common to see them collect in full and then "give back" the amount of your escrow balance after closing via a check in the mail. I wouldn't do it this way. This just inflates your balance even more than necessary. What you need to ask is for your lender to "net your escrows" meaning they will still collect in full your escrows, but will apply your existing escrow balance to your loan payoff.
(#3) The Payoff
Perhaps the most overlooked items in your balance increase is the payoff. Here's the thing... your loan balance is not your payoff. If you have a loan balance of $498,396 and your interest rate is 4.25%, your payoff amount will be higher because of the interest Per-Diem you owed since you made your last payment. Remember that interest accrues in arrears. Additionally, lenders (if they do this correctly) will estimate about 30 to 40 days of interest and add that to the principal balance to estimate your payoff. WARNING: If you see your lender quote the principal balance as your payoff, expect a rude awakening at closing. They have probably underestimated your loan amount and you will need to cut a check at closing. So here is the math. If I owed $498,396 at 4.25% interest and I call to get a payoff on 3/20, the bank quotes the amount owed, plus 20 days of interest ($498,396 x 4.25%)/360 x 20. They will then tack on about 10 days of interest so the title company has time to get them the funds and are not short. Therefore the amount added to your principal balance to get your payoff is $1,765.15 making your payoff $500,161.
Lenders add to your principal balance the cost of refinancing, the setting up of your new escrow account and interest for your loan payoff. This large amount makes it feel that a refinance is costlier than it really is. Keep in mind that you do not have to increase your balance that much. You can ask your lender to estimate your loan amount so that you bring "a payment" to closing. Personally, I'd keep the cash, skip a payment and take a breather from making a mortgage payment.
If you have any questions about refinancing, I would be happy to help. Just reach out to us at 571-249-5363 or email us at email@example.com. You may also visit www.loanwithrick.com and schedule a consult or even request a refinance worksheet.