You might lose thousands when refinancing your mortgage

Dear Bloggers,

When you and your spouce get into the adventure of buying property you need to borrow some money if you are a regular Joe like me and no I did not marry a rich chick like Paris Hilton. So you end up at a bank (too expensive and complicated as I didn’t have a regular job.) I am not a financial wizard and yes I must admit my wife understands these things better than I do.

We had just borrowed about two hundred thousand Euros and my question was pretty simple: "How do we pay you back?"

The woman on the other end of the phone, however, couldn't tell me. Ten days had passed since we signed the papers to refinance our home and, with the summer holidays approaching, I was worried our first payment would be late. She tried to soothe me with perhaps the most misunderstood phrase of the refinancing process: "Don't worry. You get to skip a payment."

Had I listened to her, it would have cost us thousands of euros. And if you are one of the millions of homeowners who will refinance in 2013, it could cost you, too. 

If your resolution is to save money or get control of the family budget, refinancing remains a really good option. But the idea that “skipping” the first payment can be pain free, financially speaking, is a myth, repeated over and over by loan officers like mine. Sometimes they are lying, sometimes they are misinformed and sometimes they are just trying to get an annoying borrower like me off the phone. But with rare exception, they are giving bad advice. (News flash: Whenever a bank seems to be doing you a favor, it probably has a hand in your wallet.)

Real estate transactions are already confusing enough. There are questions surrounding when you make your last payment on the old loan, when you make your first payment on the new loan, how many extra days of interest you pay toward both your old and your new loan, and when you are paying for both loans. We'll get to those tricky issues in a moment, but the priciest mistake you might make in a refinance is also the simplest one to correct. 

You've heard this before, but this time, it's probably true: mortgage interest rates are at historic lows, and there may never be a better time to refinance.  It's hard to imagine rates going any lower than the 3 percent range they are at now, but it's easy to imagine that, at the first signs of a real economic recovery or real inflation, they will climb sharply during 2013.  The low interest rates that the Nedrlandse Bank has imposed to boost the economy have been punishing for many, notably savers, who can barely earn 1 percent interest on their bank accounts and certificates of deposit. The one perk for consumers from the bank’s interest rate policy is the ability to get cheap home and auto loans. If you haven't refinanced your mortgage in the past 24 months or so, you are missing out.

Fortunately, many Dutch homeowners have gotten the message. According to the Mortgage Bankers Association, mortgage holders engaged in €603 billion worth of refinancing in 2012. In fact, more than four out of five new mortgages in 2012 were refinanced loans, not home purchases.
I wish there was a way to know how many of those borrowers chose to skip that first payment.

'Can I get that in writing?' 'No'

My loan officer was lazy, I believe, and -- knowing that my loan had closed and all the commissions were guaranteed -- just wanted her off the phone as soon as possible. My wife’s  call was unusual.  She is always overly cautious when she sets up any kind of new loan payment, as the chances for error are great: a wrong loan number on a payment, a bad address, etc. So she always makes the first payment early to make sure nothing goes wrong.  That good habit proved profitable this time.

When we signed the loan papers, there were no payment instructions in the closing documents (not terribly unusual). My loan officer said I would receive payment coupons later.  But when 10 days passed, and we heard nothing, She called them and She was sent to the bank's customer service line, where she was informed that there was no record of our loan. (Did that mean we didn’t have to pay it back? Sadly, No.) 

Customer service transferred me back to my loan officer. She assured me that their computers would catch up to my urge to pay the loan, and we’d get payment information soon. Incredulous that they seemed not to want my money, My wife persisted. She tapped a few keys on her keyboard, made us wait a minute, then told us that our loan had funded on May, so I didn't have to make a payment until June. 1.
"But my documents say repayment begins May. 1," I said. "So you're saying there will be no late fees if I don't pay May. 1?"
"
Yes," she said.

"Can I get that in writing.?”

"No. I can't do that."

At that point, I did what any mature consumer would do: I laughed. And then I muttered something about the 100 pieces of paper they just made me sign, with innocuous documents putting the finest point on everything you can imagine, like the form I initialed in multiple places agreeing that, yes, I am known by Jake, Jacob, Mr.J. and various other nicknames. Yet I couldn’t get the bank to put something in writing saying when we should make our loan payment?

Our loan officer didn't laugh, but eventually she put my wife on the phone with a supervisor who sounded very grave. She'd done additional research, she said, and found out that the reason customer service couldn't find my loan was because it had already been sold to another bank. 

Steep penalty anyway
But I'm not writing to warn you about late fees. There's a much bigger culprit here you have to worry about.  Had I followed my loan officer's advice and skipped a payment, even if the bank waived the late fee (which the manager said was likely), I would have paid a steep penalty anyway.  You've probably guessed the punch line: there's no such thing as skipping a payment. In reality, homeowners are borrowing that money and extending the loan term for an extra month.  The payment will be tacked onto the end of the loan, with interest.  How much? If it's a conventional loan, that’s 30 years’ worth of interest.  Effectively, you are borrowing one month's payment for 30 years. Ouch!

"Skipping is a misnomer. A better description would be ‘deferring with additional interest added,'" 
Just how much extra interest can skipping that first payment cost you? There are too many variables to create a decent rule of thumb. But let me give you an example of how I think it would be. A payment that is miniscule to one is a fortune to another. I’ll give you the numbers, then you can answer your own question. They are for a €100,000 on a 30-year loan at 6 %.

The initial interest payment on a €100,000 loan at 6% is €500. It is .06 times 100,000 divided by 12. If you skip the first payment, the €500 is added to the balance, making it €100,500. In the following month, your interest payment will be €502.50. The additional €2.50 is on the €500 you skipped. Further, the interest payment will remain higher throughout the remainder of the life of the loan, relative to what it would have been had you not skipped the first payment.

 
If your loan runs for the full 30 years, you will end up paying an additional €2993 of interest. If you pay the balance off after 15 years, it will cost €864 in additional interest. If you pay off in 5 or 10 years, it drops to €205 and €486.

Forget the €75 late fee. That's real money. Hmmm...a payment that is miniscule to one is a fortune to another.

Some loan officers say they only won't offer the "skip-a-payment" option unless the refinance closes toward the end of the month, when the homeowner might have trouble coming up with the extra cash for closing costs and a fresh mortgage payment close together.  Others say they offer it all the time.

To be clear: Most borrowers don’t actually complete their 30-year loans before moving or refinancing, so few would end up paying that high a penalty. Also, it's important to note that my bank didn't even hold the loan, so they weren't profiting from the “skip-a-payment” advice.  I believe this is usually a lazy mistake, not a greedy one. Still, the basic truth holds.  Don't be tempted to skip a payment when you refinance unless you really, really need the cash for some unusual expense ( Christmas credit card bills are probably not the best reason.)

Skipped payments are not to be confused with other loan closing related interest payments, including:

Your last payment on the old loan. You can't skip that, either. If your loan closes near the end of the month, you should still make the scheduled payment to your old bank. Why?  Interest is actually paid in arrears, meaning you pay at the end of the month the cost of borrowing the money for that month.  It's confusing, because mortgage payments are really two payments at once -- last month's interest and next month's principal.  

To keep it simple, if your loan closes on the Nov. 30, you will be paying November's interest with your Dec. 1 payment, along with December’s principal. You won't need to make the December principal payment if you refinance on Nov. 30, but most folks pay far more in interest than principal because they are early in their loan's term, so the overpayment won't be large. Just pay it to avoid late fees, and enjoy any refund that comes your way. 

Pre-paid interest. When your loan closes in the middle of the month, your new bank will make you pay up-front (as opposed to in arrears) daily interest for the remaining days of the month. If you close on the 20th, you'll pay 10 more days of interest payments.  That's OK, it means you won't owe the money on the back end of the loan.

It's important to keep all these quirky, refinance-related interest payments straight when talking to your loan officer, so you'll know what to do when he or she suggests you can skip a payment. 

None of this should scare you away from refinancing, which is really the only way you can make the recession work for you.

But remember, you are refinancing to save money, and you probably shopped around trying to save €50 here or €100 there on closing costs; don't lose thousands of Euros because of one false move after closing.

The Old Sailor,