When to Refinance

The rule widely published years ago was to only refinance if you could lower your mortgage interest rate by at least two percentage points. This general rule of thumb was a simple way to analyze the refinance, allowing consumers to consider the rough costs of refinancing. That rule no longer holds true in today's market, because you can refinance your mortgage for no closing costs, or no points.

When a refinance costs you nothing, any savings in the rate is pure gravy. ``No-Closing Cost'' refinances are just one of the ``2% rule'' breakers. We'll discuss these and other reasons to consider refinancing in this article.

Here are some of the most popular reasons to refinance:

``No Closing Cost'' Loans

Any loan where the lender pays all of your closing costs (like title & escrow fees, appraisal, lender's fees, etc.), is commonly referred to as a ``no-cost'' loan. A true ``no-closing cost'' loan differs from both a ``no lender fee'' loan or a loan in which the lender adds the closing costs to the amount financed. A ``no lender fee'' loan, sometimes advertised by banks, usually will not cover the title, escrow, and other outside charges you may need to complete the refinance.

With a true ``no-closing cost'' loan, you can refinance for any incremental drop in your interest rate since the transaction costs are zero. Even in a declining rate market, where you believe rates may continue to fall, a no-cost loan will make sense. Should rates continue to decrease you will have invested nothing in the loan costs, and can simply refinance at any time. Some borrowers refinance every year or less!

No cost loans will always carry a slightly higher rate than a loan that does not pay your costs. In general, a no cost loan is the better strategy if you plan to keep your loan for the next two and a half to three years. Longer than that, you should consider paying the costs yourself to get a lower rate. Over time, the lower rate will save you more money. And if you plan to keep the loan for four to five years, it often makes sense to pay points to get an even lower rate.

Lower your Monthly Mortgage Payment

One of the most common reasons for refinancing is to lower the monthly payment. The analysis here is simple. Ask your mortgage source what the costs involved are (all costs, not just the lender's fees). Verify this by asking what loan amount the new payment is based on. Then take the cost of the refinance and divide by your monthly savings to determine the ``break-even'' point in time. As long as you plan to keep that loan for some time longer than the break-even point, it's advantageous to refinance.

Even with a loan that includes costs, at times it may make sense to lower your payment by wrapping the costs into the new loan balance. Just be aware that the costs are increasing your principal balance owed and still do the analysis above. By following this strategy of increasing your mortgage balance, you are borrowing against your home's equity.

Of course with a no cost refinance, the break-even is immediate since you are reducing your payments without investing in the closing fees or increasing your outstanding loan balance.

Sample Analysis

Let's assume that your original loan was for $200,000 and your interest rate is 8.0%, with payments of $1,469.21. Perhaps you've had the loan for 3 years and the balance is paid down to approximately $194,500. After talking to a mortgage source, you are quoted 7.75% with payments of $1,409.51. ``Why, that's a savings of almost $60/month'' they tell you. But what about the closing costs? Remember to ask if there are any costs, and if so, how are they paid? By the lender or will they be included in the amount financed? We'll show you how to make the right decision.

In this example, the lender is proposing to include the $2,000 in closing costs into the new loan balance of $196,500. At 7.75% the new loan will give you a lower payment, but it is still worthwhile to consider the costs that are being financed. While the payment is lower than your current loan, you must also keep in mind that the loan period is being extended by stretching the larger loan balance out over a new 30 year term.

In this example, with a savings of approximately $60 per month, recouping the closing costs will take 34 months, which is explained in the table below. In this current interest rate market, you should be able to keep your break-even point at 24 months or less. Try a different mortgage, look for lower costs, or monitor the market until rates improve slightly.

 

Existing Loan Refinance
Loan Amount $200,000 $194,500 + $2000 = $196,500
Rate 8% 7.75%
Payment $1,469.21 $1,409.51
Savings - $59.70/mo.
Break even Calculation

$2000/59.70 = 34 months

Other loan programs may be available to help lower your payment without relying on the strategy of wrapping your closing costs into the loan balance. You may want to consider a shorter fixed term, such as a 5 or 7 Year Fixed that converts to an Adjustable Rate Mortgage (ARM), an annually changing Adjustable Rate Mortgage, or a loan with a monthly payment option plan (and then pay only the minimum payment possible.)

Switch from an Adjustable Rate Mortgage (ARM) to a Fixed Rate Loan

Has your adjustable (ARM) moved up on you in the last few years? Don't feel like starting with another low rate and watching it move up all over again? Consider refinancing into the security of a fixed rate loan but remember that all fixed rate loans are not the same.

Today's market offers numerous choices for loans that are fixed for a shorter time than the traditional 30 or 15 years. Loans are available with fixed rates for 3, 5, 7, and 10 years and the shorter the initial fixed period, the lower the interest rate. All of these loans are amortized over 30 years so there's no need to worry about the payment being too high. All you need to do is match up how long you expect to keep the loan with the closest fixed term. This may be shorter than how long you plan on keeping your home, if you feel comfortable with the refinance process.

At the end of the fixed term, these loans automatically convert into ARMs with adjustments annually, so there is no balloon payment. TIP: As the market shifts around daily and weekly, you might be able to get a 7 year near the cost of a 5 year, so keep your eyes on both.

Often the current fixed rates will be somewhat above the rate on your current ARM, unless you are several years into your adjustable. You will need to decide if the security and insurance against further rate increases is worth the additional payment that you might incur.

Switch from a Fixed Rate Loan to an Adjustable Rate Mortgage (ARM)

OK, you're probably wondering what's going on. One minute we suggest getting out of an adjustable, and then turn around and suggest you go into an adjustable. But it really can make sense in some situations.

If you've recently decided to start looking for a new home, or will be relocating within the next few years, it may make sense to evaluate your current loan. By switching from a 30 year fixed to a low rate adjustable or short term fixed, such as a 3 Year Fixed, you can save substantially over the remaining time that you'll be in your home. In this type of situation it almost never makes sense to pay closing costs, so shop for a no cost loan with a slightly higher rate. Also, don't take a loan with a prepayment penalty, unless the prepayment is waived upon sale of the home. This strategy can be best explained by showing an example. For simplicity, we're assuming that your loan balance is the same on both the refinance and original loan.

 

30 Year Fixed One Year ARM
Loan Amount $300,000 $300,000
Rate 7.875% 6.5%
Payment $2175 $1896
Monthly Savings - $279
Annual Savings - $3348

Take cash out of your home

The primary advantage of home mortgage loans is that the interest costs are deductible for tax purposes. If you are currently paying a higher rate of interest on credit cards, car loans, or other forms of debt that are not deductible, it may make sense to pull the cash out of your home (provided that you have the equity) and use it to pay off those other debts.

Lenders will typically allow you to borrow up to 75% of the appraised value of your home in a cash out refinance. (Some lenders will go up to 80%, however the loans offered will be less competitive than at 75%.) Paying off other bills or credit cards, buying a new car, sending the kids to college, investing in an Internet start-up, or buying additional real estate are all good reasons to refinance your home and take cash out.

Even if you're able to keep you credit card interest rate at 8-9% with low introductory offers, when you consider the tax savings of your mortgage interest, you will be paying less interest if those balances were part of your mortgage instead. If you are paying 8% on your mortgage and your tax bracket is 33%, your net interest rate is 5.3% which is still less expensive than any credit card program over time.

Eliminate Mortgage Insurance (MI)

If you purchased your home with less than 20% down, chances are you have a loan that is insured by ``Mortgage Insurance'' (MI). Most borrowers are aware that they are paying MI on a monthly basis, but you can check your mortgage statement if you're not sure. As your home appreciates or your loan balance decreases (or a combination of the two), your equity in the home will exceed 20%. At that time a favored method of eliminating the MI tied to the loan is to refinance. The savings of eliminating the MI alone will often warrant refinancing.

Be aware that mortgage lenders value your property at what comparable homes have sold for in the last 6 months, not what they are currently listed for. If you are close to that 20% mark, ask your mortgage source to provide you with a ``comp search'' estimate (this service should be available for free) which will give you an idea of how your lender will view your home's value.

If you are currently in a low rate fixed mortgage, don't refinance simply to remove MI. Instead, work with the existing mortgage holder so that you can keep that low rate and still reduce your payment by removing the mortgage insurance premium. Since the lender does not have as strong an incentive as you to eliminate the MI portion of your payment, there sometimes appears to be an unwillingness to assist in this process of removing the mortgage insurance. Do not be discouraged by the lack of information or cooperation if you do encounter some resistance. Request in writing the lender's policy on eliminating MI and work with the lender until they have satisfied you.

But I Don't Want to Extend my Loan Term!

On a final note, some people hold on to their loans simply because they do not want to extend the remaining time that they'll be paying on a mortgage. If you are five years into a 30 year fixed loan, with 25 years remaining, how can you be certain that you're making the right choice by refinancing into a lower rate? Doesn't the fact that you're potentially extending your loan term wipe out the potential savings of the lower rate? Absolutely not!

The simplest way to prove this is to take the new loan, and amortize it over the remaining term of your current loan. That is, assume that you still want to pay off your loan in 25 years, and then calculate what your payments need to be to make this happen. Now compare your total payments with the new lower rate mortgage versus your existing loan. If your total payments over the remaining term are lower this means that you're paying less interest, and it makes sense to refinance. Since all lenders will accept an additional payment towards principal on a monthly basis, you can be certain that your loan will get paid off on time and you'll save on interest costs. Let's let the numbers speak for themselves.