Three things regarding the present state of mortgages are clear:
1. Mortgage interest rates are currently at or near their lowest point in three decades.
2. They are unlikely to go lower.
3. Exactly how soon they will go up, no one knows for sure, but the latest news indicates that it will be by the end of this year.
So, if you own a home, now is an excellent time to consider refinancing -- or refinancing again.
A refinance mortgage (known as a “refi”) is a loan on your currently owned property. With the proceeds of this new loan, you pay off the existing mortgage (or mortgages). Generally, there are two types of refinance mortgages:
• “No-cash-out” refi’s are mortgages in which the amount borrowed doesn’t exceed the mortgage debt currently owed. Such loans may require you to pay points and closing costs out-of-pocket.
Mortgages on which you pay points charge a lower interest rate than those with no points. Each point – an up-front interest fee paid on a mortgage – is equal to 1 percent of the amount you borrow. The more points you pay, the lower your mortgage interest rate will be – about 0.5 percent to 1 percent less than the rate on a no-point mortgage.
Closing costs are the up-front fees lenders charge to process your mortgage. These fees include things such as the home appraisal, title search, document preparation fees, filing and recording fees, and closing attorney fees. (Note that while tax and insurance escrows and private mortgage insurance premiums may be collected along with the closing costs, they should not be considered part of the closing costs.)
Although closing costs will vary depending on the size of the loan, they generally total about $1,500 to $2,500. Mortgages without closing costs are often available, but they generally carry an interest rate about 0.25 percent higher than mortgages on which closing costs are paid.
• “Cash-out” refi’s are mortgages in which the total amount borrowed exceeds the debt currently owed – for example, when you take out additional monies to renovate your home, or when there is no current mortgage on your property before the refinance (because either you already paid off the mortgage or there never was a mortgage).
With some exceptions, all mortgage products available for the purchase of a home are also available for a refinance. Generally, with a no-cash-out refi, up to 95 percent of a home’s appraised value can be borrowed; with a cash-out refi, only about 75 percent to 85 percent of a home’s value can be borrowed. Some lenders now offer refi’s for which 100 percent or more of the home’s appraised value can be borrowed, but it isn’t a good idea to refinance for this amount unless you’re doing major renovations.
When It Pays to Refinance
The following questions will help you decide whether you can save by refinancing and which type of loan will save you the most money:
When should I consider a “no-cash-out” refi?
Refinance when you can save money by getting a lower interest rate and/or when you can gain security by switching from an adjustable to a fixed-rate mortgage (never refinance to an adjustable-rate mortgage).
As for the old rule of thumb – “never refinance unless you can drop the interest rate by at least 2 percent” – it was never a particularly good rule. Instead, before you refinance, be certain that the amount you’ll save on your monthly mortgage payment will “pay back” the cost of refinancing within the remaining time you plan to own the property, and preferably much sooner – within about four to five years maximum.
To determine how long it will take to pay off the refi costs, divide the cost of refinancing (points, closing costs and, if required, private mortgage insurance) by the amount you’ll save each month – as illustrated in scenarios A and B below.
It may be difficult to know exactly how long you’ll retain ownership, but generally you shouldn’t refinance unless:
• you plan to own the property for another four to five years; or
• you can lower your interest rate with a “no-point, no-closing-cost” loan.
Should I refinance if I already have a relatively low interest rate?
Yes, as long as you can recoup the cost of points and closing costs within four or five years, or you can lower your rate with a “no-point, no-closing cost” mortgage. When shopping for a mortgage, ask prospective lenders to “run the numbers” on any loan you’re considering to determine how long it will take you to recoup the cost of refinancing.
The following scenarios will help you determine your break-even point:
• Scenario A – You plan to stay in your home for at least five more years. Suppose you took a 15-year fixed-rate mortgage of $200,000 at 6.5 percent on your home 3.5 years ago. If you refinance today to a 15-year fixed-rate mortgage at 5.25 percent, paying two points (2 x $2,000) and $2,000 in closing costs, the refi would cost you $6,000. Here, you’d save just over $134 per month on your mortgage payment, which means it would take you just under four years to recoup the $6,000 cost of refinancing ($6,000 divided by $134 = 44.7 months). So, in this case, refinancing while paying points and closing costs is a good idea.
• Scenario B – You plan to move within the next two to three years. In this case, a “no-point, no-closing cost” mortgage may be a viable option. Currently, such loans are available for as low as 5.875 percent on a 15-year mortgage, as long as you borrow at least a minimum amount (currently about $75,000 to $85,000).
The savings per month will be much less. Using the numbers from scenario A above, dropping your rate from 6.5 to 5.875 percent would save you just under $68 per month. But, because the cost of refinancing will be nonexistent (or very low – generally less than $800 if private mortgage insurance is required), refinancing will still be worth the effort.
The one drawback is that by refinancing back to a 15-year mortgage, you’re stretching out the length of the mortgage – in the above examples, by 3.5 years. So, to get the fullest savings from your refinance, either:
1. Add enough to your new monthly mortgage payments to pay off the new mortgage over the same time period as was left on your prior mortgage, or
2. Consider refinancing to a shorter-length mortgage (in this case, a 10-year mortgage).
It should be noted that, anyone who has had their current 15-year mortgage for at least two years should consider refinancing to a shorter-term 10-year mortgage (or, if your current mortgage is for 30 years and you’ve had it for at least five years, consider refinancing to a 20-, 15- or 10-year mortgage). However, since refinancing to a shorter-term mortgage – while still saving you money over the course of the loan – may actually raise your monthly payment, never choose this route unless you’re certain you can afford the higher monthly payment.
Should I refinance again if I refinanced recently?
Yes, refinance as long as the time needed to recoup the cost of this refinance – plus whatever costs you’ve yet to recoup from the previous refinance – will be five years or less. Or, refinance if you can lower your rate with a “no-point, no-closing cost” loan.
When should I consider refinancing to a shorter (20-, 15- or 10-year) mortgage?
As noted above, consider a shorter-term mortgage if you’ve had your current 15-year mortgage for at least two years (or your current 30-year mortgage for at least five years). The one major caveat is if you have any concern that you may have difficulty making the monthly payments on a shorter-term loan (now, or at any time in the future), then opt for a mortgage that is the same length as your current mortgage (30, 20 or 15 years).
With its lower monthly payments, the longer-term mortgage will cost considerably more in the long run. But taking the longer-term loan does allow you to make additional principal payments on the mortgage each month to shorten its term (when you are able and want to do so), while retaining the safety of paying the lower monthly payments (whenever you don’t want or can’t afford to make additional payments toward the principal).
When should I consider a “cash-out” refinance?
Here, the answer is a bit more complicated. While the refinance will lower your interest rate, you may not “save” any money on your monthly payment, because you’ll be borrowing more than you currently owe. Here, you should calculate whether the refinance would be worthwhile if you were borrowing only what you currently owe on the mortgage (that is, if it were a “no-cash-out” refi).
No matter what this calculation may show, take these precautions before moving forward on a “cash-out” refi:
• Don’t use the cash from a “cash-out” refi for non-essential consumer expenses or items – generally, anything other than repairs or improvements that add significant value to your home, or emergency medical costs.
• Don’t use “cash-out” to pay off other consumer debt – credit cards, car loans, etc. – if you are now or could in the future be in financial difficulty. Switching such non-secured consumer debt to a mortgage secured by your home increases the possibility of losing your home through foreclosure if you are in, or run into, financial difficulty.
If you do take cash-out to pay off other debt, promise yourself you’ll pay off the cash-out portion of the refinance mortgage over the same time period you’d have paid off the consumer debt.
For example, if you take $10,000 cash-out on a refi to pay off a car loan on which you have three years of payments left, be certain you pay down an additional $10,000 on the principal balance owed within the first three years of the refinance mortgage. If you don’t, you defeat the cost-saving purpose of taking cash-out to pay off the higher-interest-rate consumer debt.
Should I borrow through a bank or a mortgage company?
Because all lenders generally are governed by the same regulations, look for the best rate and terms – regardless of whether the source is a bank or a mortgage company.
Do all lenders offer the same rate?
If your credit is good and your income level qualifies for the size loan you want, interest rates on similar type loans won’t vary greatly. Nevertheless, all lenders do not offer exactly the same rates. So, once you’ve decided what type of mortgage you want, shop around for the best rate and make sure you’re comparing apples to apples.
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Rick Shaffer is an attorney, writer and host of “The Money Show,” a call-in radio show.