If you’ve been anywhere near buying or refinancing a home, you must’ve definitely heard of the term ‘Loan Estimate’. If you’ve ever wondered what items appear on the loan estimate from a potential lender, what are closing costs and how to calculate the actual closing costs for your loan, we have the answers for you. So, let’s dive right in.
A loan estimate is the document that you receive from a potential lender once you apply for a mortgage. It carries all the important information of your loan which include (but not limited to) your loan amount, estimated interest rate (which is not final till you lock it) and monthly payment. It also carries the cost to complete your mortgage application commonly known as ‘closing costs’.
Though a loan estimate is provided whether you are buying a new home or refinancing an existing home, in this article, we will be discussing the items applicable to refinancing an existing mortgage.
Below are the two pages of a typical mortgage refinance loan estimate belonging to a John Doe that was issued on the 13th of May 2020.
Let us now break down the foremost items that you need to pay close attention to:
The estimated property value is the current value of the property that you provide to the lender. This value is eventually validated by the lender through an appraisal. Rather than making educated assumptions it is always best to provide an accurate and factual property value.
If you are pursuing a regular refinance to just reduce the interest rate or change the loan term and not a cash out refinance, you want to make sure that this loan amount matches the principal that you owe on your current mortgage. If it’s higher, then you are most likely rolling the refinance costs into your loan. Which you shouldn’t unless that’s what you really want. It might sound simple, but you want to make sure the loan amount matches.
The estimated property value and the loan amount are the two numbers that determine your LTV or Loan to Value. LTV is the ratio of the loan amount to the estimated property value. In John Doe’s sample, the LTV is 84.94% ($361,000 / $425,000 = 84.94%). Make a note of this LTV as we will come back to this shortly.
Ideally, we want to target an interest rate that is at par or below the Nation’s average at the time of application without buying points. Generally speaking, a credit score of 720+ should give you the best rates. In this particular case, as you can see in the below image, the average rate was around 3.28% in mid-May. And John has got a rate of 2.99% which means he has received a very competitive rate.
Then comes the monthly principal and interest which is standard and is determined by the loan amount, interest rate and the loan term which in John’s case is 30 years.
Next, it’s the Private Mortgage Insurance popularly known as PMI. This is an insurance that protects your lender if you default on your loan. You are obligated to pay this PMI if your LTV that we discussed earlier is more than 80%. You can avoid PMI if you reduce your loan amount (and bring your LTV down to 80%) by bringing in your own money to the table while refinancing but that depends on your financial situation.
Here is a very important tip on PMI. On most of the traditional, low risk loans, the PMI may be eliminated once your loan to value ratio reaches 80%. But you have to manually request for it. Because it is likely that there is a clause in your mortgage contract that says the PMI payments will not be automatically terminated until the LTV reaches 78%.
When you do manually request this termination however, depending on where you live and how long you’ve had the loan, the lender may order for an appraisal that you may have to pay for. But most lenders wouldn’t want an appraisal if they have no reason to believe that your home value has gone down and if you have had the loan for more than a year while making your payments on-time.
We know that when John starts the loan, his LTV is 84.94%. As he continues his payments, according to the ‘Automatic termination’ clause on the PMI disclosure that you see below, his PMI will be automatically terminated on May 1, 2024, the date his LTV will reach 78%.
However, there is also a ‘Borrower requested cancellation’ clause (see below) on the same PMI disclosure. Based on this, John can call his lender the day after May 1,2023 – which is the date his LTV will reach 80% and have the PMI payments terminated by manually requesting for it!
That is a one whole year of PMI payments that John doesn’t have to pay to his lender!
In this example, by making that single phone call, John could save $51 x 12 months = $612 in PMI payments for the period it took the LTV to go from 80% to 78%. So, do yourself a favor and please set a reminder for the date when your PMI is scheduled to hit 80%. Call your lender on that date asking the PMI be removed from your monthly payments. You can find this date on your PMI disclosure form.
Next, it’s the Estimated Escrow Payments – this payment goes towards building the funds to pay the home owner’s insurance of your choice, the state’s property tax, Home owners’ association dues, etc. The money you pay each month goes in to an Escrow account. And is used when one of the above-mentioned bills is due. If your LTV is less than 80%, you may be able to avoid an escrow account and handle these dues yourselves. But, this is regulated by your state, and if the state allows, then you do have a choice here.
Now let us move on to the more important second page of the loan estimate which carries the closing cost details.
The Origination charges include origination fee, underwriting fee, processing fee, points, etc. This section basically has the fees that you pay the lender to complete your loan refinancing in addition to any points that you may buy. As far as points are concerned, let us not go into much detail but it’s generally not a good idea to buy points.
Ideally, you want the origination charges to be ZERO. But, in some cases, a fee here might be acceptable and we will explain this in detail in our next blog post which is on how you can possibly refinance your mortgage at no cost to you AND still score a competitive interest rate. So, please subscribe to our newsletter so you don’t miss this post!
In most cases, Section B will have an Appraisal fee, and few other fees like the ones you see which you will have to pay for the refinance. In this case, the appraisal was waived and hence you don’t see that fee here.
This section is the Title related charges. As the name suggests, you can and should shop for these services till you are convinced that you have gotten the best rates for them. Google for title companies near you and email them for quotes. If you receive quotes that are better than what your lender offers, ask your lender to switch to the title company that you found. Please do this in the early stage of your loan application.
This section is just the total of sections A, B and C
Please note that the above charges might be considerably high in some states.
As the name says, these are prepaids. Depending on when you are closing the loan, you might only have the prepaid interest part of this. But you could have other items. Like if you are planning to get a new home owner’s insurance, or if you are closing right around when your property taxes are due, etc.
Prepaid interest is collected for days between the funding date of your new loan and the 1st of the following month. This can be equated to the interest that you would have paid anyway, even if you had not refinanced. So, you are not throwing away anything here and prepaids should not be considered as “fees” towards refinancing.
That looks like a big-ticket item, right? Most people stay away from refinancing thinking there is a lot of “fees” involved. Yes, there certainly are fees involved, but this big-item in Section G is not one of those. All you are doing here is funding your escrow account with several months’ worth of Homeowner’s Insurance and the Property Taxes so it can be paid by the loan servicer when it’s due. The number of months you will need to fund depends on your loan and your state’s escrow rules. But, in the end, it is very important to note that the items in Section F and G should not be considered as fees towards refinancing as they are not.
The costs in this section is usually applicable if you are purchasing a home and may not be applicable when refinancing. But you might want to double check if there are any other costs as far as your particular case is concerned.
This section is just the total of sections E, F, G and H
This section shows the total amount that you owe for refinancing your mortgage. So, when people look at Section J and see $5,704, they think “Well, it is going to cost me almost $6,000 just to refinance”? and they decide that it is too expensive and opt not to refinance.
But considering the information that we discussed so far, let’s calculate what the real refinance costs are as per John’s loan estimate.
Total Costs = A + B + C + E since F and G should not be considered as costs
So, in this case,
Total Costs = 1,638 + 112 + 925 + 40 = $2,715 which doesn’t seem too bad, right?
When refinancing, you have to understand what your break-even period is and here is where knowing the real costs of refinancing helps you make the right decision.
The break-even period is calculated using the “fees” or the “cost” you pay for the refinance. And as a result, the savings you will avail on your monthly payment. In our example, let’s say John lowers his payment by $200 per month by refinancing from a 30-year 4% loan to a 30-year 2.99% loan.
If you consider the entire $5700 as his closing costs, then his breakeven period will be almost 29 months ($5700 / $200). What this break-even period means is that John should keep his loan and his house at least for a period of 29 months to justify his refinancing.
However, we now know that his real costs are only $2715 as the rest of the payment are either for prepaids or escrow and shouldn’t be considered as refinance cost. So now, his real break-even period is less than 14 months ($2715 / $200). Which also means that John should keep his loan and his house only for 14 months. This difference could be the deciding factor for some people on whether or not they should proceed with refinancing.
So, now that you have familiarized yourself with all the important items of a loan estimate, here is our conclusion based on the information that you have learned from this article.
Do not put added pressure on your refinancing decision by assuming that the costs involved in Section F – which contains the prepaids, and Section G – which contains the escrow payments, are part of your refinancing fees. Understand the “real” fees or cost of refinance to calculate your beak-even period and then make your decision.