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Home Refinancing Basics

Even though more than half of all new mortgages issued in recent years have been for homeowners refinancing their existing home loans, the decision to refinance isn’t necessarily the wisest strategy for everyone. The most important fact to consider is whether the savings from refinancing will compensate for the cost of the refinancing itself. If you don’t plan to stay in your home long enough to break even, refinancing could be a mistake.

For those homeowners who do decide to refinance, there are several other variables to consider. For example, although short-term mortgages typically offer lower interest rates than long-term mortgages, they usually involve higher monthly payments. On the other hand, they can result in significantly reduced interest costs over time. There is also a significant difference between a fixed-rate mortgage and an adjustable rate mortgage. The former allows a borrower to "lock in" a permanent rate, whereas the interest rate on the latter could go up in the future. In addition, some mortgages charge fees called "points" up front, but may offer lower interest rates in return. Always remember to check with your current lender about refinancing — your existing relationship could allow you to realize big savings in terms of both time and money.

In recent years, Americans seeking to take advantage of low interest rates have lined up to refinance their mortgages -- often resulting in significantly lower monthly payments.

But while it's true that refinancing has the potential to help you reduce the costs associated with borrowing money to own a home, it is not necessarily a strategy that makes sense for every individual in every situation. So before you make a commitment to refinance your mortgage, its important to do your homework and determine whether such a move is the right one for you.

To Refinance or Not

The old and arbitrary rule of thumb said that a refi only makes sense if you can lower your interest rate by at least two percentage points for example, from 6% to 4%. But what really matters is how long it will take you to break even and whether you plan to stay in your home that long. In other words, make sure you understand -- and are comfortable with -- the amount of time it will take for your overall savings to compensate for the cost of the refinancing.

Consider this: If you had a 30-year $200,000 mortgage with a 6.5% interest rate, your monthly payment would be $1,264. If you refinanced at 4.5%, your new monthly payment would be $1,013, a savings of $251 per month. Assuming that your new closing costs amounted to $2,000, it would take eight months to break even. ($251 x 8 = $2,008). If you planned to stay in your home for at least eight more months, then a refi would be appropriate under these conditions. If you planned to sell the house before then, you might not want to bother refinancing. (See below for additional examples.)

Remember — All Mortgages Are Not Created Equal

Don't make the mistake of choosing a mortgage based only on its stated annual percentage rate (APR), because there are a variety of other important variables to consider, such as:

The term of the mortgage — This describes the amount of time it will take you to pay off the loan's principal and interest. Although short-term mortgages typically offer lower interest rates than long-term mortgages, they usually involve higher monthly payments. On the other hand, they can result in significantly reduced interest costs over time.

The variability of the interest rate — There are two basic types of mortgages: those with "fixed" (i.e., unchanging) interest rates and those with variable rates, which can change after a predetermined amount of time has passed, such as one year or five years. While an adjustable-rate mortgage (ARM) usually offers a lower introductory rate than a fixed-rate mortgage with a comparable term, the ARM's rate could jump in the future if interest rates rise. If you plan to stay in your home for a long time, it may make sense to opt for the predictability and security of a fixed rate, whereas an ARM might make sense if you plan to sell before its rate is allowed to go up. Also keep in mind that interest rates have hovered near historical lows in recent years and are more likely to increase than decrease over time.

How Much Would You Save?

A homeowner with a 30-year, $200,000 mortgage charging 7.5% interest would pay $1,398 each month. The table below illustrates the potential monthly savings and the various break-even periods that would result from refinancing at different rates.

Rate After RefinancingNew Monthly PaymentMonthly SavingsMonths to Break Even*
6.0%$1,199$19910
5.5%$1,136$2638
5.0%$1,074$3256
4.5%$1,013$3855
4.0%$955$4445
3.5%$898$5004

*Assumes $2,000 closing costs. Rounded up to the next highest month.

Points — Points (also known as "origination fees" or "discount fees") are fees that you pay to a lender or broker when you close the deal. While a "no cost" or "zero points" mortgage does not carry this up-front cost, it could prove to be more expensive if the lender charges a higher interest rate instead. So you'll need to determine whether the savings from a lower rate justify the added costs of paying points. (One point is equal to one percent of the loan's value.)

A Closer Look at Mortgage Fees*

Mortgage-related costs that may apply to your loan could include the following items. Source: The Federal Reserve Board, A Consumer's Guide to Mortgage Settlement Costs, August 2010. (Most recent available data.)

Application fee (median cost)$365
Loan origination fee (assuming 5% down payment on $200,000 loan)$2,734
Points0-3% of loan amount
Appraisal fee$263-$444
Home inspection fee$300-$500
Prepaid interestWill vary by loan amount and timing
Private mortgage insurance (PMI)$50-$100/Mo
Flood determination fee$12-$16
Property survey costs$84-$600

*Other settlement costs may also apply.

Stick With What You Know

Finally, keep in mind that your current lender may make it easier and cheaper to refinance than another lender would. That's because your current lender is likely to have all of your important financial information on hand already, which reduces the time and resources necessary to process your application. But don't let that be your only consideration. To make a well-informed, confident decision you'll need to shop around, crunch the numbers, and ask plenty of questions.

Points to Remember
  1. The decision to refinance should only be made if the long-term savings outweigh the initial expenses. To calculate your break-even point, divide the cost of the refi by your monthly savings. The resulting figure represents the number of months you will need to stay in the home to make the strategy work.
  2. Don't select a new mortgage based only on its annual percentage rate.
  3. Also evaluate the term of the loan, whether the interest rate is fixed or variable, and the relative merits of paying up-front fees in exchange for a lower rate.
  4. Your current lender already knows you and has your financial information on file, so you may be able to get a better deal that way, instead of going to a new lender.
  5. To get the best possible refinancing deal, you'll need to shop around, crunch some numbers, and ask a lot of questions.

 

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which course of action may be appropriate for you, consult your financial advisor.

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