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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Thursday, August 19, 2010

Should You Consider Refinancing Now?

Today, interest rates on fixed-rate 30-year mortgages were reported to be 4.42 percent, the lowest rate we’ve seen in years. So, this begs the question: “Should you consider refinancing your home mortgage loan?” Before even analyzing this, in general, you have to have at least a 90% loan to value (current market value) ratio in order to qualify for a refinance. For many people, especially those who bought their houses in the last 10 or so years with little money down, refinancing is not an option, unless they have somehow increased their equity position by making extra payments or by improving the property.

In the past, when mortgages were not as large as they are today, the rule of thumb for refinancing was that you needed to be able to obtain a new mortgage with at least a two percent lower rate of interest. Now, with mortgages typically larger (although in many cases not as large as a couple of years ago, due to the decrease in home prices), many advisers say that a one percent lower interest rate can justify a refinance.

The bottom line is: How long will it take for you to recoup the cost of obtaining the new mortgage (i.e., cover the closing costs: points, appraisal costs, etc.). If it will take only a year or two, it’s probably worth considering. If it will take more than a few years, it may not be appropriate. Also, if you only plan to be in your home for only a few more years, refinancing is not likely justified.

There are many reasons that might motivate you to refinance besides obtaining a lower interest rate:

(1) If you’ve had your mortgage for some time and the payment is constraining your budget, refinancing for another 30 years could lower you payments significantly and give you some breathing room.
(2) You may currently have an adjustable-rate mortgage (ARM) and are concerned about the real possibility of rising interest rates. A fixed-rate mortgage at today’s low rates could protect you from the threat of rising interest rates many worry are not far down the road.
(3) You may have improved your credit rating significantly. Refinancing could give you a significantly lower rate than you currently are paying due to both the current lower rates available and the fact that you have improved your credit worthiness.
(4) If your income has increased significantly, (you received a raise or your spouse went back to work), you may want to refinance to take advantage of the lower rates and to take out a shorter mortgage (15 years instead of 30 years). The total cost of a fifteen-year mortgage is substantially less than the total cost of a 30-year mortgage even though the payments may be higher.
(5) If you are currently paying for private mortgage insurance (PMI) because you couldn’t put 20% down when you took out your mortgage but have since made major improvements to your home or prices have increased such that your equity is now more than 20%, you should seek to have the PMI coverage eliminated. A current appraisal will be required. If your lender won’t eliminate the PMI, you can consider refinancing with another lender.
(6) If you have significant other debt, you may want to refinance to consolidate your debt and take advantage of the fact that home mortgage interest is deductible while other personal loan interest is not. This may be OK to do if you are a very disciplined person and can avoid racking up new debt. In many cases, however, people have a lot of personal debt because they are in fact not disciplined. We do not generally recommend refinancing to consolidate debt.

If you do decide to look into refinancing, get quotes from several lenders. Check out each lender with your state financial regulator and Better Business Bureau. Ask for a good faith estimate, which shows what all the costs of closing are and how much the lender will make. If there are no closing costs, the loan will typically have a higher interest rate. Determine what you will have to pay at closing. If closing costs are rolled into the mortgage principal, it will reduce your equity and take you longer to pay off the loan. Request a re-issue rate on your title insurance.

Your monthly savings will be equal to your new payment (Principal, Interest plus PMI, if any) minus your current payment. The payback period is obtained by dividing your total closing costs by the monthly savings. The longer the payback period, the less desirable it would be to refinance.

You also need to consider the total cost of refinancing. If the cost of the new mortgage plus what you’ve already paid on the current mortgage is more than the total cost of the original mortgage, then refinancing is generally not advisable. Whatever you do, don’t let just one lender talk you into refinancing based on monthly payment alone. You need to look at the whole picture and get quotes from at least three providers.


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