Deciding To
Refinance
Traditionally, the
decision on whether or not to refinance has meant balancing the
savings of a lower monthly payment against the costs of
refinancing. But in recent years, companies have introduced "no
cost" and low-cost refinancing packages that minimize or
completely eliminate the out-of-pocket expenses of refinancing.
(These refinancing packages compensate with a higher interest
rate, or by including some of the costs in the amount that is
financed.)
With traditional
refinancing, the most often cited rule-of-thumb is that the
interest rate for your new mortgage must be about 2 percentage
points below the rate of your current mortgage for refinancing to
make sense. However, with the newer low- and no-cost refinancing
programs, it can be worth your while to refinance to obtain a
smaller reduction in interest rates.
How long you expect to
stay in your home is also a factor to consider. If you'll be
moving in a few years, the month-to-month savings may never add up
to the costs that are involved in a refinancing.
Consider Other
Mortgage Programs
If you are thinking
about refinancing your mortgage, you might want to consider other
types of mortgages. For example, you might want to look into a
15-year, fixed-rate mortgage. In this plan, your mortgage payments
are somewhat higher than a longer-term loan, but you pay
substantially less interest over the life of the loan and build
equity more quickly. (Of course, this also means you have less
interest to deduct on your income tax return.)
You also might want to
consider refinancing if you have an adjustable rate mortgage with
high or no limits on interest rate increases. You might want to
switch to a fixed-rate mortgage or to an adjustable rate mortgage
that limits changes in the rate at each adjustment date as well as
over the life of the loan.
If you decide to apply
for refinancing with a particular mortgage company, and if you do
not want to let the interest rate "float" until closing, get a
written statement to guarantee the interest rate and the number of
discount points that you will pay at closing. This binding
commitment or "lock-in" ensures that the mortgage company will not
raise these costs even if rates increase before you settle on the
new loan. You also may consider requesting an agreement where the
interest rate can decrease but not increase before closing. If you
cannot get the mortgage company to put this information in
writing, you may wish to choose one that will provide this
important information.
Most companies place a
limit on the length of time (say, 60 days) they will guarantee the
interest rate. You must sign the loan during that time or lose the
benefit of that particular rate. Because many people refinance
their mortgages when rates decline, there may be a delay in
processing the papers. Therefore, you may want to contact the
company periodically to check on the progress of your loan
approval and to see if additional information is needed.
Paying Points For
A Lower Rate
In refinancing, a
mortgage company usually offers a range of interest rates at
different amounts of points. A point equals one percent of the
loan amount. For example, three points on a $100,000 mortgage loan
would add $3,000 to the refinancing charges.
Analyzing various
interest rates and associated points may save you money. As a rule
of thumb, each point adds about one-eighth to one-quarter of one
percent to the interest rate the mortgage company is offering.
Generally, the lower
the interest rate on the loan, the more points the lending
institution will charge. Some companies offer refinancing with no
points, but generally charge higher interest rates.
To decide what
combination of rate and points is best for you, balance the amount
you can pay up front with the amount you can pay monthly. The less
time that you keep the loan, the more expensive points become. If
you plan to stay in your house for a long time, then it may be
worthwhile to pay additional points to obtain a lower interest
rate.
Some companies may
offer to finance the points so that you do not have to pay them up
front. This means that the points will be added to your loan
balance, and you will pay a finance charge on them. Although this
may enable you to get the financing, it also will increase the
amount of your monthly payments.
Analyze Your
Savings
Check the market
closely to determine the available rates and the costs associated
with refinancing. These costs can include items such as an
appraisal and other various fees and points. Then determine what
your new payment would be if you refinanced. You can estimate how
long it will take to recover the costs of refinancing by dividing
your closing costs by the difference between your new and old
payments (your monthly savings). However, the ultimate amount you
may save depends on many factors, including your total refinancing
costs, whether you sell your home in the near future, and the
effects of refinancing on your taxes. The old rule of thumb used
to be that you shouldn't refinance unless the new interest rate is
at least two percentage points lower. However, many companies are
now offering zero point loans and low-cost refinancing. Therefore,
even if your rate change is less than one percentage point, you
may be able to save some money by refinancing.
Refinance Costs
When you refinance
your mortgage, you usually pay off your original mortgage and sign
a new loan. With a new loan, you again pay most of the same costs
you paid to get your original mortgage. These can include
settlement costs, discount points, and other fees. You also may be
charged a penalty for paying off your original loan early,
although some states prohibit this. The total expense for
refinancing a mortgage depends on the interest rate, number of
points, and other costs required to obtain a loan. To obtain the
lowest rate offered, most mortgage companies will charge several
points, and the total cost can run between three and six percent
of the total amount you borrow. So, for example, on a $100,000
mortgage, the company might charge you between $3,000 and $6,000.
However, some companies may offer zero points at a higher interest
rate, which may significantly reduce your initial costs, although
your payments may be somewhat higher.
Get Some Cash
Another way to make a
refinance work for you is to refinance for more than the balance
remaining on your old mortgage -- in effect, tapping your home
equity, or "cashing out," in mortgage speak. Thanks to favorable
rates, you may be able to do so without boosting your monthly
outlay. For example, at 8.5%, the payment on a $200,000, 30-year
fixed-rate mortgage is $1,538. But at 7.5%, that same payment lets
you borrow nearly $20,000 more.
The best use for the
extra cash is to pay off any higher-rate loans you may have. Let's
say that you are carrying a $15,000 car loan at 10% and making
minimum payments on a $10,000 credit-card balance at 17%. Your
monthly payments on those debts would total $680. Then assume you
refinanced your mortgage, taking out an additional $25,000 to pay
off your car and credit-card loans. Result: At 7.5%, your
additional monthly mortgage payment would total only $175, so you
would come out $505 ahead ($680-$175=$505).
Of course, all the
extra cash needn't go for paying off debts. When the Jones
swapped their ARM for a fixed-rate last December, they also
increased their mortgage load by $34,000, from $106,000 to
$140,000. They used $3,000 of the proceeds to pay their
refinancing costs and another $17,000 to pay off a 10% home-equity
loan, which had been costing them $250 a month. Then they spent
the remaining $14,000 to build a garage for Roger's antique-car
collection -- and they did all this for just another $19 a month.
Your Personal
Taxes
With a lower interest
rate on your home loan, you will have less interest to deduct on
your income tax return. That, of course, may increase your tax
payments and decrease the total savings you might obtain from a
new, lower-interest mortgage.
You should be aware of
an Internal Revenue Service (IRS) ruling with respect to points
paid solely for refinancing your home mortgage. IRS regulations
require that interest (points) paid up front for refinancing must
be deducted over the life of the loan, not in the year you
refinance, unless the loan is for home improvements. This means
that if you paid a certain number of points, you would have to
spread the tax deduction for those points over the life of the
loan. If, however, the loan or a portion of the loan is for home
improvements, you may be able to deduct the points or a portion of
the points. Check with the IRS regarding the current rulings on
refinancing, particularly if you are using the new loan to make
home improvements.
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