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What Do I Need to Know About Refinancing My Mortgage?

Authored By: D.C. Bar Pro Bono Center

FAQ

What is equity?

Equity is the financial value of your homeownership.Equity has many advantages. These include financial independence, control over your own home, and the financial value of the house.

How do I figure out how much equity I have?

The Equity Equation: the Value of Home - Amount Owed = Equity.

Here are some examples:

Mortgage loan to the Smiths:

How much equity do the Smiths have?

On the day they buy their home for $145,000:

The Smiths owe to the lender for their mortgage:

$140,000

The property is worth:

$145,000

How much equity do the Smiths have?

$5,000

After 5 years of on-time payments:

 

The Smiths owe on their mortgage:

$133,097

If the property is now worth:

$180,000

How much equity do the Smiths have?

$46,913

After 20 years of on-time payments:

 

The Smiths owe on their mortgage:

$84,669

If the property is now worth:

$250,000

How much equity do the Smiths have?

$165,331

How do you increase your equity?

  • Reduce the amount you owe.Make your mortgage payments. Avoid taking on new mortgage loans.
  • Increase the value of your home: Maintain your home. Make improvements to your home. Be involved in block clubs or homeowners associations to keep neighborhood home values higher
  • The real estate market.This is determined by the overall housing market in the Greater DC area. But generally, over the long term, property values tend to increase.

What can you do with equity? 

Equity is wealth. Once you acquire equity, it is yours to keep unless you give it away to someone else. With equity you can:

  • Live "rent free" once your mortgage is paid.
  • Use it to help buy a new home if you need to move .
  • Pass it on to your children.

Why do people refinance their mortgages?

  • They get into debt.
  • They want spending money.
  • They fall for the sales pitch.

What are the drawbacks of refinancing?

  • You may lose your equityif you increase the debt attached to your home (remember the equity equation).
  • You may lose money if you have to pay fees and other expenses to refinance your home, and you have to pay more interest.
  • If you cannot pay the new loan, you may lose your home in a foreclosure.

What is a predatory loan?

A loan is predatory if the lender charges you more than a reasonable amount for your loan. Usually, a predatory lender uses aggressive sales tactics and ignores or glosses over the high-cost features of the loan.

What a salesperson should tell you about your loan:

  • Amount you will receive
  • Your monthly payment

The other things you need to know:

Before you decide to borrow money, you need to look at several things to determine whether the loan is a good deal for you. These include:

  • the interest rate
  • whether there is a balloon payment
  • what fees you will have to pay
  • whether you can prepay the loan.

These terms will be explained below.

You should receive two documents every time you receive a loan:

  • The first is a truth-in-lending statement. This is a document that tells you how much interest you will have to pay on your loan.
  • The other is a settlement statement that tells you all the fees and other costs you will have to pay when you receive the loan.

Most of the information discussed in this section will appear on these forms.

What is an Interest Rate?

Interest is an amount charged to you every month. It is a percentage of the amount you owe on your loan. The higher the percentage, the more you pay.

Here are some examples of how interest works:

Each of these loans is for $140,000, to be paid back in full over 30 years. See how the cost of the loan increases when the interest rate increases.

 

7% (moderate)

12% (high)

Monthly payment:

$931

$1,440

Total payments over 30 years:

$335,315

$518,413

Total interest over 30 years:

$195,315

$378,413

How is your interest rate determined?

A lender determines your interest rate based on two factors:

  • The first is the general market (how much are people in general paying to get a loan).
  • The second is based on your own credit rating. Sometimes people pay higher interest rates because they do not have a good credit rating. Your credit rating is determined by your credit score, which measures whether you are considered a "good risk" to lend money to.The higher your credit score, the better your credit rating and the lower the amount of interest you will pay.

How is your credit score determined?

Credit agencies collect information from all the people to whom you owe money. Based on these reports, the credit agencies give you a credit score. Your credit score is made up of a number of factors.The factors that credit agencies take into account include:

  • your bill-paying history
  • the number and type of credit cards and other loans you have
  • whether you make your payments on time
  • how much money you owe compared to your income
  • whether you have ever failed to pay any amount you owe
  • whether you have declared bankruptcy in the past.

A credit score helps predict how likely it is that you will repay a loan and make the payments on time.

What is a Balloon Payment?

Sometimes lenders hide the true costs of the loan by decreasing the monthly payments. Low payments sound good until you have to make a balloon payment at the end of the loan.

A balloon payment is a large final payment that is due at the end of the loan because the monthly payments were not high enough to pay off the loan at the interest rate set by the lender. The balloon payment is for more than the amount of money you save on your monthly payment.

Here is an example of how a balloon payment works:

Each of these loans is for $140,000 over 30 years at 7 percent interest. The only difference is the amount of the monthly payments.

 

Loan #1

Loan #2

Monthly payments

$931

$750

Total payments (without balloon)

$335,315

$270,000

Balloon payment

N/A

$222,622

Total cost

$335,315

$492,622



 

What are Finance Fees?

Finance fees are charges for borrowing the money. With most bank loans, finance fees are paid up front. You write a check to the bank to cover the cost of the fees at the time you receive the loan, and the fees are usually a few thousand dollars.

With a high cost loan, the fees are added to the loan. This looks like a good deal, because you don't have to pay them up front. However, the lender just adds them to the amount of the loan, and then charges interest on these fees, adding even more cost to you.

What sorts of fees do they charge?

Credit Life Insurance

Credit life insurance is insurance that will pay off your loan in the event that you pass away before its term is over. You are not required to buy this insurance in order to qualify for a loan. Credit life insurance is usually more expensive than other types of life insurance. In addition, it usually expires after seven years, or before the loan is paid off, and the amount of the insurance decreases each year, as the amount due under the loan decreases.

In some cases, the lender charges the entire amount of potential premiums up front and then charges interest on the amount to the borrower. If you feel that you need life insurance to cover the amount of a loan, you would be better off shopping for a separate policy.

Points, Origination Fee, Finance Charge

These are fees you have to pay when you borrow money. If you get a bank loan, your fees will usually not exceed 2 percent or 3 percent of the loan. However, with a high cost, predatory loan, the fees can exceed 5 percent of the loan. With a bank, you usually pay these fees up front. With a high cost loan, the fees are added to the loan, and you end up paying interest on the fees as well.

Professional Services, Loan Preparation Fees

These are fees for lawyers, appraisers and title searches. Often, with a high cost loan, these fees can be inflated.

Closing Costs

These are the costs for recording your deed and mortgage with the registrar of deeds as well as transfer taxes. These are generally legitimate.

The effect of all of these costs can be shown in the following example. In each case the borrower wanted to borrow $140,000, to be paid back fully over 30 years.

 

Moderate Fee

7% Interest

High Fee

12% Interest

Amount borrowed:

$140,000

$140,000

Credit life insurance:

N/A

$6,000

Points, origination fees and finance charges

$1,400

$4,200

Professional services, loan preparation fees and closing costs:

$2,500

$4,500

Amount you have to pay (not including interest):

$143,900

$154,700

Total amount you have to pay (including interest):

$335,315

$572,855


 

Adding Up the Costs

The high fee lender above charged $10,800 more in fees and costs than the moderate rate lender. But the cost to the borrower was even more because the borrower did not pay the extra fees up front. The lender charged interest on these fees, for a total extra cost to the borrower of almost $51,434!

What else do I need to look out for?

In addition to the high costs there are other things you have to watch out for to make sure your loan is not a predatory loan. These include:

Prepayment Penalties

As you know, interest rates can change over time. Sometimes interest rates go down. What happens if you still have a high interest rate loan when interest rates go down? Well, you can refinance your loan. Even though you will have to pay some additional costs, you can still save on interest payments-which means it is still a good deal. In addition, if you have had credit problems, but have been able to sort them out, you can qualify for a lower interest loan.

However, with high-cost, predatory loans, there are often significant prepayment penalties. This means that you have to pay thousands of dollars extra if you want to pay off your loan early. By adding prepayment penalties to the loan, the lender can trap you into a high interest loan.

Arbitration Clauses

If someone treats you unfairly, and you sign a bad contract, you can always go to court, right? Not necessarily. Many predatory lenders put into their loans mandatory arbitration clauses. Under an arbitration clause, your case is heard by a layperson, instead of a judge.

Sometimes, arbitration clauses can be good, because they provide a way for you to solve your problems quickly, without having to go to court. However, in the case of predatory loans, the contract may provide that the arbitration will take place in an inconvenient location, hundreds of miles from your home-perhaps even in another state. You may also have to pay for part or all of the arbitration-which can cost hundreds or even thousands of dollars.

All of these provisions are designed to discourage you from protecting your rights. Be sure to review your loan documents to see if they contain an arbitration clause.

Flipping

Predatory lenders make a lot of money by "flipping" loans (refinancing your loan over a very short period of time). Each time a loan is refinanced the lender can charge more finance fees and continue collecting payments. In some cases this can go on indefinitely.

Steering

Predatory lenders will often charge you a higher interest rate even though you have a good credit history and qualify for a lower interest rate. You should know your credit score and shop around to see if some other lender will give you a lower interest rate.

What are some alternatives to refinancing my home?

Avoid falling into situations where you feel you need to refinance:

  • Be smart with your money.
  • Beware of rent-to-own, credit cards, home repair and improvement offers and other potential scams.

If you get into trouble, explore alternatives:

  • Know Your Rights
    • See a credit counselor. BE CAREFUL IN CHOOSING A COUNSELOR. Many credit counselors charge you large fees, and others are set up by predatory lenders to try and sell you a high cost loan. Make a plan to pay off your credit cards and other debt.
    • If you think about consolidating your debt, shop around and get professional advice.
  • Get your Credit Report

You have a right to see your credit report. Federal law provides that you have the right to get a free annual credit report from the three companies that keep track of your credit history. The three companies are: Transunion, Experian and Equifax. You can get a copy of your reports from each of these creditors by visiting www.annualcreditreport.com. Once you get a copy of your credit report, you should review it and correct any mistakes that are on your report, such as any amount it says you owe, but you do not. You should then use your credit report to help determine whether you are receiving a fair deal on your loan.

  • Disclosure statements

You have a right to see your truth-in-lending statement and your settlement statement at least 24 hours before you close on the loan. This will give you time to review the terms of the loan and have them reviewed by an attorney or consumer credit counselor before you close. Therefore, you should ask to review these documents before you close on any loan and seek the advice of an expert who you can trust.

  • Three business days to cancel

If you want, you can cancel your loan, without any penalty, within three business days after to the loan is made. In some cases you may have more than three days. Therefore, even if you have already signed the papers you may be able cancel the loan. You may have other rights as well. If you think you may have entered into a predatory loan, you should consult an attorney or consumer rights advocate as soon as possible to see what your rights are.

  • Call the Office of the Attorney General

In certain cases, your loan may be covered by the Home Loan Protection Act. This is a law that applies to mortgages secured by property in the District of Columbia. It restricts, and in some cases prohibits, certain predatory loan practices. It applies to so-called "high cost loans" where the interest rate is between 6%-7% higher that the rate charged on US Treasury securities or the points and fees payable on the loan exceed 5% of the total loan amount. If you feel that you have been the victim of a predatory loan, you should also contact the Department of Insurance, Securities and Banking at (202) 727-8000 to see how you can protect your rights.

Last Review and Update: Apr 28, 2006