The Best Way to Refinance a Small Mortgage

The Best Way to Refinance a Small Mortgage

A reader asked me about refinancing a mortgage. I gave him my usual spiel about getting a no cost refinance, stepping down the ladder, etc. I also gave him the short list of lenders I shop from: First IB, NMA, and AmeriSave.

He came back to me saying he couldn’t get a no cost refi from any of them because the balance on his current mortgage is too small.

To get a decent rate for 30-year fixed, he’ll have to pay $1,500 to $2,000 in closing cost. It just doesn’t make much sense to pay that much to refinance a small mortgage. So what is the best way to refinance a small mortgage?

How Small Is Small?

Much of the closing cost is fixed regardless of the balance. Appraisal costs a few hundred dollars whether your mortgage balance is $400k or $100k. Escrow agent charges a few hundred dollars regardless. The cost of title insurance has something to do with the mortgage balance but it’s not completely linear (at least not linear everywhere). I picked a random zip code and got quotes from Entitle Direct. On a $400k mortgage, title insurance costs $357. On a $100k mortgage, it still costs $228.

On the other hand, the lender credit you get from paying a slightly higher interest rate is a percentage of the loan size. A small mortgage simply can’t get a large enough lender credit to offset the largely fixed closing cost, unless the rate is so high that it gets close to the current rate.

Does it mean that once your mortgage balance gets below $100k you are pretty much stuck? Not necessarily. You have to go a little off the beaten path.

Solution #1: Cash-Out Refi

I used a cash-out refi on my own mortgage refinance. It requires a low loan-to-value (LTV) ratio. The mortgage balance is small but the value of the home isn’t. The lender I used offered cash-out refi at maximum 60% LTV without a rate penalty.

If you do a cash-out refi to increase the size of the loan to 60% LTV, when you multiply the size of the new loan by the percentage for the lender credit, the resulting dollars may be able to cover the relatively fixed closing cost and still make it a no-cost refi.

After the refi closes, you pay the cash-out back against principal. Because your loan size is higher now, although spread over a longer loan term, your required monthly payment may be higher.

Solution #2: Home Equity Loan

Many banks will pay closing costs on a home equity loan. While a Home Equity Line of Credit (HELOC) typically carries a variable interest rate, a Home Equity Loan (HEL) can have a fixed rate. After you use the Home Equity Loan to pay off your current mortgage, the Home Equity Loan works pretty much just like a mortgage.

A Home Equity Loan typically has shorter terms. You don’t get a 30-year term but you can get a 10-year or 15-year fixed rate Home Equity Loan. For a small loan size, a 10-year or 15-year fixed rate Home Equity Loan compares favorably to a 10-year or 15-year mortgage because you won’t have to pay the $1,500-to-$2,000 closing cost.

Pentagon Federal Credit Union (PenFed) offers a home equity loan for owner-occupied homes at maximum 80% LTV at good rates. PenFed will pay all closing costs on a home equity loan. It only requires that you keep the loan for at least two years. Otherwise you will have to reimburse them for the closing costs.

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