The decision to refinance depends on many variables. How long have you owned
the home? How long do you expect to continue to hold an ownership position? Has
your ability to qualify for financing changed since you took out your original
loan? Do the savings justify the cost or the hassle? Will you incur a penalty if
you pay off your current loan too soon?
Why Refinance?
Most people refinance to lower their monthly mortgage payments. If rates
have come down significantly since you obtained your original loan, you may be
able to cut your payments substantially. But there are other reasons to turn in
your old loan, too.
Perhaps you want to reach into the equity that's built up in your home since
you bought it. In that case, you can do a "cash-out refi" by taking out a new
mortgage based on the home's current worth, pay off what you still owe on the
old loan and pocket the difference.
Or maybe you want to shorten the period you'll be making payments. You can do
that by swapping your current 30-year mortgage for a 15-year loan or one of
practically any other duration. If rates have come down enough, you may even be
able to achieve this with little or no increase in your monthly outlay.
Another reason to refinance might be to jump from an adjustable-rate mortgage
(ARM) - where your rate changes with market conditions - to a fixed-rate loan
which offers the certainty of set payment amounts no matter what happens to
mortgage rates in the future. Or, since ARMs often start off at rates
substantially lower than those charged for fixed loans, you might want to go the
other way and take advantage of a particularly low introductory ARM rate. You
might even want to switch from an ARM which is about to be more costly (the
rate's going up) to another ARM with a lower starting rate. Your options are
practically endless.
When to Refinance
At one time, the general rule of thumb was that it paid to refinance only
when the current rate is two percentage points lower than what you are currently
paying. But with the advent of "no- cost" refinancing options, that precept is
no longer valid. However, the term "no-cost" is something of a misnomer. It
doesn't mean free; it means you won't have to pay anything out of your own
pocket at the time of closing. Either the fees charged by the lender will be
rolled into your new loan balance or the rate will be somewhat higher than you
could obtain if you paid the lender's charges up-front.
Still, the real determinant is how long it will take to recoup your costs.
One idea is to weigh monthly savings against up-front costs. If you can save
$100 a month on your mortgage payment by refinancing, but you have to pay $2,500
for the privilege, then you have to keep the new loan for at least 25 months to
make up the difference. If you're planning to move sooner, it doesn't pay to
refinance. But if you are going to stay in the house longer, refinancing is
usually a sound financial decision.
When Not to Refinance
The missing link in all of this is how long you've held your current
mortgage. Because you will be starting all over again with a brand new mortgage,
the longer you have had your present loan, the less advantageous it is to
refinance, especially if the difference between your old and new interest rate
isn't significant.
Consider someone who wants to trade in a four-year-old loan on which he has
already paid $25,000 in interest. By starting over, he could be paying more in
interest for both loans than if he had stuck with the old one, depending on the
difference in rates. You should do the math before making a final decision.
Remember, your house payments in the early years of your loan are almost all
interest. Popular wisdom has it that interest isn't so bad because it's
deductible. But interest isn't all it's cracked up to be. For one thing,
interest is cash out of pocket - your pocket. Yes, every dollar you pay in
interest is deductible on your tax return, but your tax savings is only
equivalent to your tax bracket. So if you are in, say, the 31 percent bracket,
your net write-off is just 31 cents, not a full $1.
The only sound way around this problem is to switch to a loan with a shorter
term, say 15 years rather than 30. Your monthly savings may not be significant,
but you'll be shaving years off your loan, so your total interest costs won't be
as great.
Another potential roadblock: A prepayment penalty clause in your current
mortgage.
Many lenders now charge borrowers a penalty if they pay off their loans
before a certain period. Usually, that's no more than two years, but sometimes
it's five. The fee, which might be as much as a percentage of the unpaid balance
or as little as a full month's interest, protects lenders against losing loans
before they become profitable. In exchange, the borrower usually gets a slight
break on his or her interest rate. But if rates fall during the penalty phase of
the loan, the charge is one more cost you have to absorb.
Prepayment penalties are illegal in mortgages insured or guaranteed by the
federal government and some other loans. Your loan documents will tell you
whether your mortgage contains such a clause as well as the length of the
penalty period and the fee.
