Refinancing Your Home

Refinancing options

When you’re making your decision, there are several things to keep in mind.

First, even a small rate cut can pay off quickly. That’s because you can easily find mortgage companies willing to waive routine refinancing charges such as application, appraisal and legal fees (which can add up to $1,500 to $3,000). Of course, in exchange for low or no up-front costs, you’ll have to be willing to accept a rate that’s somewhat higher than the prevailing rock bottom.

Second, if you are planning to stay in your home for at least three to five years, it may make sense to pay “points” (a point equals 1% of the loan amount) and closing costs to get the lowest available rate.

And third, you can avoid laying out cash and still get a low rate by adding the points and closing costs to your new mortgage. Does that mean shouldering a lot of extra debt? Not necessarily. If you’ve had your current mortgage for at least three years, you’ve probably reduced your balance by several thousand dollars. So you may be able to tack your closing costs onto your new loan and still end up with a mortgage that’s smaller than your original one — plus, of course, a lower rate and lower monthly payment.

Refinance once, then do it again

When rates fall steadily, refinancing may make sense even if you have done so once already. Bob and Michelle Barbo of Kirkland, Wash. refinanced twice within three months in 1998. In October, they trimmed the rate on their 30-year fixed mortgage by a full point — from 9.13% to 8.13% — for a monthly savings of $63. Plus, because home prices in their area had boosted their home equity, they were able to stop paying private mortgage insurance that cost them $120 a month.

To exploit continued decline in rates, the Barbos refinanced again in December. Their new 30-year fixed mortgage is at 7.375%, lopping another $55 off their monthly bill. Since the couple had chosen a no-cost refinancing each time, their total out-of-pocket expenses came to just $400 in appraisal fees. So by the time you read this, they will already have recouped their up front costs. “Now we can use the savings to build up a cash emergency fund,” says Bob.

If you are considering a second refinancing, don’t overlook this potential tax write-off: When you pay points to refinance, you must deduct the amount over the life of the loan, usually 30 years. But when you refinance a second time, all of the points that have not yet been deducted from the first refinancing can be written off in a lump sum. Say you refinanced to a 30-year mortgage in 1993 and paid $3,000 in points. By now, you would have written off roughly $500. If you refinance again this year, you could deduct the remaining $2,500 on your 1998 tax return. For a homeowner in the 28% tax bracket, that works out to a savings of $700 — enough to offset some or all of your costs this time around.

Build home equity faster

Many borrowers use a refinance to shorten the term of the mortgage. And brace yourself: Even at low rates, a shorter term means a higher monthly payment. The benefit is that you’ll build up equity faster and pay far less in total interest over the life of the loan.

Consider Jim Neill, 48, a real estate broker and his wife Merrilyn, 55, a psychotherapist. Recently, the couple took out a 15-year fixed-rate loan at 6.75% to replace an 8.13% ARM with a 30-year term. Their monthly payment jumped by $200, but now they will own their own home outright by the time they retire. In addition, the total interest on the 15-year loan will come to $95,447, vs. $222,234 on the remaining life of the ARM — and that assumes their adjustable rate would have held steady at its current 8.13%. “This is forced savings,” says Jim. “When we retire, we can scale down and take equity out of the house.”

If you can’t afford the payments on a 15-year mortgage, your next best means of building equity is to refinance for less than 30 years. To do so, ask your mortgage company to customize your new loan’s term to match the years that are left on your old loan — if you are five years into a 30-year mortgage, for example, ask for a 25-year loan.

Get your hands on some cash

Another way to make a refinance work for you is to refinance for more than the balance remaining on your old mortgage — in effect, tapping your home equity, or “cashing out,” in mortgage speak. Thanks to favorable rates, you may be able to do so without boosting your monthly outlay. For example, at 8.5%, the payment on a $200,000, 30-year fixed-rate mortgage is $1,538. But at 7.5%, that same payment lets you borrow nearly $20,000 more.

The best use for the extra cash is to pay off any higher-rate loans you may have. Let’s say that you are carrying a $15,000 car loan at 10% and making minimum payments on a $10,000 credit-card balance at 17%. Your monthly payments on those debts would total $680. Then assume you refinanced your mortgage, taking out an additional $25,000 to pay off your car and credit-card loans. Result: At 7.5%, your additional monthly mortgage payment would total only $175, so you would come out $505 ahead ($680-$175=$505).

Of course, all the extra cash needn’t go for paying off debts. When the Menards swapped their ARM for a fixed-rate last December, they also increased their mortgage load by $34,000, from $106,000 to $140,000. They used $3,000 of the proceeds to pay their refinancing costs and another $17,000 to pay off a 10% home-equity loan, which had been costing them $250 a month. Then they spent the remaining $14,000 to build a garage for Roger’s antique-car collection — and they did all this for just another $19 a month.

Trade your ARM for a fixed rate

By switching to a fixed-rate loan, you will not only reduce your payment, you will also likely lock in an attractive rate for as long as you own your home.

In fact, while one-year ARMs currently offer tempting introductory rates averaging 5.59%, most experts recommend avoiding them, because you could easily find yourself facing sharply higher payments in the near future, even if interest rates don’t rise. Why? Well, after the introductory rate expires, ARMs are typically pegged to the one-year Treasury rate (recently 5.25%) plus 2.75 percentage points, with increases of as much as two points a year. Assuming interest rates don’t change, you would pay 7.59% in the second year (the full two-point increase) and 8% in the third year.

There are certain cases, however, where an ARM makes sense. If you are fairly certain you’ll be moving within five years, you can save some money — and avoid rising payments — with a five-year ARM, recently averaging 6.62%. Such loans offer a fixed rate for five years and adjust annually thereafter.

Refinance costs

When you refinance your mortgage, you usually pay off your original mortgage and sign a new loan. With a new loan, you again pay most of the same costs you paid to get your original mortgage. These can include settlement costs, discount points, and other fees. You also may be charged a penalty for paying off your original loan early, although some states prohibit this. The total expense for refinancing a mortgage depends on the interest rate, number of points, and other costs required to obtain a loan. To obtain the lowest rate offered, most mortgage companies will charge several points, and the total cost can run between three and six percent of the total amount you borrow. So, for example, on a $100,000 mortgage, the company might charge you between $3,000 and $6,000. However, some companies may offer zero points at a higher interest rate, which may significantly reduce your initial costs, although your payments may be somewhat higher.

Analyze your savings

Check the market closely to determine the available rates and the costs associated with refinancing. These costs can include items such as an appraisal and other various fees and points. Then determine what your new payment would be if you refinanced. You can estimate how long it will take to recover the costs of refinancing by dividing your closing costs by the difference between your new and old payments (your monthly savings). However, the ultimate amount you may save depends on many factors, including your total refinancing costs, whether you sell your home in the near future, and the effects of refinancing on your taxes. The old rule of thumb used to be that you shouldn’t refinance unless the new interest rate is at least two percentage points lower. However, many companies are now offering zero point loans and low-cost refinancing. Therefore, even if your rate change is less than one percentage point, you may be able to save some money by refinancing.

Paying points for a lower rate

In refinancing, a mortgage company usually offers a range of interest rates at different amounts of points. A point equals one percent of the loan amount. For example, three points on a $100,000 mortgage loan would add $3,000 to the refinancing charges.

Analyzing various interest rates and associated points may save you money. As a rule of thumb, each point adds about one-eighth to one-quarter of one percent to the interest rate the mortgage company is offering.

Generally, the lower the interest rate on the loan, the more points the lending institution will charge. Some companies offer refinancing with no points, but generally charge higher interest rates.

To decide what combination of rate and points is best for you, balance the amount you can pay up front with the amount you can pay monthly. The less time that you keep the loan, the more expensive points become. If you plan to stay in your house for a long time, then it may be worthwhile to pay additional points to obtain a lower interest rate.

Some companies may offer to finance the points so that you do not have to pay them up front. This means that the points will be added to your loan balance, and you will pay a finance charge on them. Although this may enable you to get the financing, it also will increase the amount of your monthly payments.

Your personal taxes

With a lower interest rate on your home loan, you will have less interest to deduct on your income tax return. That, of course, may increase your tax payments and decrease the total savings you might obtain from a new, lower-interest mortgage.

You should be aware of an Internal Revenue Service (IRS) ruling with respect to points paid solely for refinancing your home mortgage. IRS regulations require that interest (points) paid up front for refinancing must be deducted over the life of the loan, not in the year you refinance, unless the loan is for home improvements. This means that if you paid a certain number of points, you would have to spread the tax deduction for those points over the life of the loan. If, however, the loan or a portion of the loan is for home improvements, you may be able to deduct the points or a portion of the points. Check with the IRS regarding the current rulings on refinancing, particularly if you are using the new loan to make home improvements.

Consider other mortgage options

If you are thinking about refinancing your mortgage, you might want to consider other types of mortgages. For example, you might want to look into a 15-year, fixed-rate mortgage. In this plan, your mortgage payments are somewhat higher than a longer-term loan, but you pay substantially less interest over the life of the loan and build equity more quickly. (Of course, this also means you have less interest to deduct on your income tax return.)

You also might want to consider refinancing if you have an adjustable rate mortgage with high or no limits on interest rate increases. You might want to switch to a fixed-rate mortgage or to an adjustable rate mortgage that limits changes in the rate at each adjustment date as well as over the life of the loan.

If you decide to apply for refinancing with a particular mortgage company, and if you do not want to let the interest rate “float” until closing, get a written statement to guarantee the interest rate and the number of discount points that you will pay at closing. This binding commitment or “lock-in” ensures that the mortgage company will not raise these costs even if rates increase before you settle on the new loan. You also may consider requesting an agreement where the interest rate can decrease but not increase before closing. If you cannot get the mortgage company to put this information in writing, you may wish to choose one that will provide this important information.

Most companies place a limit on the length of time (say, 60 days) they will guarantee the interest rate. You must sign the loan during that time or lose the benefit of that particular rate. Because many people refinance their mortgages when rates decline, there may be a delay in processing the papers. Therefore, you may want to contact the company periodically to check on the progress of your loan approval and to see if additional information is needed.

Deciding to refinance

Traditionally, the decision on whether or not to refinance has meant balancing the savings of a lower monthly payment against the costs of refinancing. But in recent years, companies have introduced “no cost” and low-cost refinancing packages that minimize or completely eliminate the out-of-pocket expenses of refinancing. (These refinancing packages compensate with a higher interest rate, or by including some of the costs in the amount that is financed.)

With traditional refinancing, the most often cited rule-of-thumb is that the interest rate for your new mortgage must be about 2 percentage points below the rate of your current mortgage for refinancing to make sense. However, with the newer low- and no-cost refinancing programs, it can be worth your while to refinance to obtain a smaller reduction in interest rates.

How long you expect to stay in your home is also a factor to consider. If you’ll be moving in a few years, the month-to-month savings may never add up to the costs that are involved in a refinancing.