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
Here are some of the most popular reasons to refinance:
- Lower your monthly mortgage payment to improve cash flow
- Switch from an Adjustable Rate Mortgage (ARM) to a fixed rate loan
- Switch from a fixed rate loan to an Adjustable Rate Mortgage (ARM)
- Free up tax-deductible cash
- Eliminate Mortgage Insurance (MI)
``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
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.
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.
||$194,500 + $2000 = $196,500|
|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
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|
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
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
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.
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