Today, I’d like to feature an email from a reader. With your help, perhaps we can guide her to making the right decision for her.

Nicole writes:

“My husband and I own a duplex that we bought three years ago that is strictly used for investment and because of our interest rate that is almost at 7%, we are looking to refinance.

However, these are the problems that we are faced with. When we called our bank to possibly refinance we found that they are willing to do it, but not at the prime rate. Because it is a rental property, the interest rate will still be a bit higher that prime, but still a 1% lower than what it is now and saving us about $120.00 a month.

Well, then through conversation, we realized that the LTV (Loan-to-value) was 80% and the PMI would be dropped, saving us another $91.00/mo. However, with their steep closing cost, (again due to it be an investment property) that they add that in to the new refinanced mortgage, that would take us back to the less than 20% invested to have the PMI removed. SO, we then asked them about just doing a rate modification, which would save us on closing cost, get our rate lowered and also allow us drop PMI. In order to do so, they gave our information to a mediation company that will lower our rate to 3% for the term of the entire loan, making our mortgage payment 700.00/mo including everything, bringing in an extra 1000.00/mo The catch is we would have to stop paying the mortgage for 2mos. while they attempt to prove a hardship. Is it worth the gamble and is it worth defaulting and hurting our credit? We are really honest people, who, for the most part, play by the rules. We feel we are getting the short end of the stick. Do we take advantage of this opportunity the way the rest of the world has?”

[Note: I’ve cleaned up some of Nicole’s informal email for grammar, spelling, and formatting for posting here…]

Before I give my thoughts on Nicole’s situation, I should clarify a few things. It’s been 4-5 years now since I’ve done anything mortgage-related. I’ve simply been making payments each month. Additionally, I’m not licensed to give financial advice, so I will give more broad commentary on what I might do.

Nicole’s situation is a little closer to mine than most questions I receive. For instance, my wife and I both own investment properties. The difference is that we didn’t buy them strictly for investment purposes and are rates are at or below 6% – locked in for 30 years. While we have noticed some lower rates out there… as Nicole mentions since it’s a rental property, we aren’t likely to get the lower rate and save any money by going in that direction.

The most interesting aspect of Nicole’s question comes from the advice she received to stop making payments to prove a hardship. I had a friend tell me that it was possible to do a similar thing. That led me to write about lowering your interest rate without refinancing. There I openly wrote about the ethics problem I had with the idea of fabricating a hardship. My rationale in the comments was that people who were doing the wrong thing were coming out in better situations than I was. I often pretend we live an ideal world, where people doing the right things are rewarded… when that doesn’t happen it tempts me to the dark side. Fortunately, I realized this and decided not to go through with it. Part of my rationale was the old adage that two wrongs don’t make a right.

I don’t want to impart my ethics on Nicole, so I won’t. She seems to have an idea where she stands with comments like being honest people and playing by the rules. If she does decide to go the route of proving a hardship, I’d take caution. It sounds like she’s getting a shady offer that’s not going to be put in writing. My experience with such offers is that they tend to disappear. It reminds me of a game of chicken where she is hoping that by continuing forward she’ll reap the rewards of a much lower rate. The downside is an ugly crash that ends with bad credit and not being able to improve on her 7% rate at all.

Personally, I’m very much the chicken who would take the small gains rather than risk it (especially with the ethics involved). I would try to find a bank with fewer closing costs. That’s always a nice, but not realistic option. Secondly, I would suggest living extra lean for a couple of months so that they can get under that PMI. Perhaps most realistically, do the refinance to knock it down to 6% under the condition that the bank will agree to drop the PMI when they get the loan amount under a certain number. The reason I would get this in writing is that you don’t want the bank to turn around and drop the value of the home, keeping the LTV above 80%. This would still save her over $210 a month and seems to come with no risk.

What do you have to say?