The Money Question: Refinancing Your Mortgage

How do I know if I should refinance my mortgage, and what's the best way to do it?
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Question: We have 18 years left on our 30-year 5.75 percent mortgage. Should we refinance?

Answer: With interest rates at historic lows, refinancing can definitely save you big bucks. The idea is simple: By trading in your current mortgage for a new one at a lower rate, you slash your monthly payment. (Some people refinance to take money out for other purposes, but I'm confining this discussion to the transfer of a balance on a fixed-rate loan to another, newer loan.) Here's how to decide if refinancing is for you.

Do Some Comparison Shopping
Interest rates vary widely. To find the lowest rates, check the websites of local banks as well as giant lenders. The conventional wisdom is to refinance only if the new rate is a full two percentage points below the current one, but, depending on the terms, refinancing can still make sense even if your rate isn't dropping that much.

Calculate the Up-Front Costs
Refinancing is not cost-free. For their best rates, lenders often charge "points" (short for "percentage points," so on a $200,000 loan, one point equals $2,000). Even if you opt for a zero-point loan (usually a better deal overall), a host of other fees can run you anywhere from $2,000 to $10,000, depending on your area (some states charge high mortgage-transfer fees, for example) and your lender's policies. These details will show up in the good faith estimate of your refinancing costs, which your lender has to provide before you sign on the dotted line.

Look at Payback Time
Use a refinance calculator (try the one at hsh.com) to figure out what your payments will be with the lower interest rate and how long it will take to recoup the total cost of refinancing, plus any points. Ideally, this period should be less than 36 months, provided you don't plan on moving before then (if you do, refinancing isn't worth it).

Consider the Terms Carefully
Unless your current mortgage is fairly new, much of your monthly savings will come from extending the total borrowing time. Some financial advisers recommend maxing out your mortgage term since (1) rates are so low, (2) interest is tax-deductible, and (3) you're unlikely to own the house for the life of the mortgage. But realize that if you trade in the mortgage you've been paying for 12 years for a new 30-year loan and stay put for the long haul, you'll have spent 42 years paying off the loan. Not only will you be signing on for 30 more years of payments, you'll also be shelling out a lot more in total interest. So I'm a big believer in refinancing for roughly the same period that's left on your current loan. In your case, a 15-year loan (which will have an even lower rate) might not produce monthly savings, but it will shorten your total term by three years, saving you thousands in interest. Or a 20-year loan could yield monthly savings while extending your loan period by just two years. If you were a few years into a 30-year loan, I'd advise refinancing for a new 30-year term, then putting half the money you'll save toward the principal of the new loan each month. Prepaying part of the principal could shorten the effective duration of the new loan to about what's remaining on your current one (bankrate.com has a good prepayment calculator).

Figure Out Your Equity
Of course, not every refinance gets approved, especially these days, when lenders are more cautious than in the recent past. Typically, you'll need a credit score of 700 or above and at least 20 percent equity in your home (by no means a sure thing given the recent drop in home prices). To help figure out whether you have this equity, check a site such as Trulia for an estimate of your house's value. Then subtract your remaining loan balances (including any home equity lines of credit) to make sure they don't total more than 80 percent of current property value.

If you don't meet that 80/20 loan-to-equity ratio -- or even if your house is underwater (meaning it's worth less than you owe) -- government-backed programs might be able to help. Check the government website Making Home Affordable. If the 80/20 ratio is too close to call, a traditional refinance is a bit of a gamble. If the bank's appraisal comes back low, your loan will be denied, and you could lose $500 to $1,000 in fees. But if your credit is strong and the potential savings are big, refinancing is definitely worth a try.

Tisa L. Silver-Canady is the assistant director of financial education and wellness at the University of Maryland, Baltimore, and the author of The Time Value of Life: Why Time Is More Valuable Than Money.

 

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