Refinancing: Should You or Shouldn’t You?
Q: Seven years ago we got a 30-year, $70,000 mortgage at 10%. With savings interest rates at 4.5% or lower, my husband and I are considering applying $50,000 from our savings toward paying off our mortgage. Does this make sense? --S.T.
A: The real question you ought to be asking yourself in this interest rate environment is whether it makes sense for you to refinance your mortgage and put your savings--as well as the money you save on monthly mortgage payments--into better-yielding investments such as a well-operated mutual fund. With rates for 30-year, fixed-rate home loans hovering in the 7.5% range--their lowest point in two decades--many homeowners are again rushing to take advantage of deals they haven’t seen before.
How can you determine whether refinancing your mortgage makes good financial sense? There are three key issues to consider: the length of time you expect to remain in the home; the difference between the interest rate you are now paying and the rate you can get by refinancing, and what the refinancing will cost you in the way of points and fees.
Another issue you might consider is whether a refinancing will allow you to switch over to a different type of mortgage--perhaps exchanging a variable-rate loan for a fixed one or substituting a 30-year mortgage for one that is paid off in 15 years. (Because mortgage interest is typically the largest income tax deduction remaining for the average homeowner, you might be tempted to worry that a lower loan payment will make you more exposed to Uncle Sam’s reach. Don’t let the tail wag the dog! If you save $3,000 in mortgage interest and end up paying the government $1,000 more in taxes because of it, you still come out $2,000 ahead.) Although the ability to take advantage of today’s low interest rates through a refinancing is a major boon to cash-strapped consumers in less than ideal economic times, the sad truth is that many homeowners who would most benefit from a refinancing will be unable to get one. Why? Home values in many parts of the country--but notably here in Southern California--have fallen over the last couple of years. Houses bought as recently as 1990 may actually be worth less today than what their owners paid for them. For these homeowners, a refinancing would likely require them to pay off the mortgage to the point that it meets the lender’s “loan-to-value” ratio, usually 70% to 80% of the property’s fair market value.
If you have owned your home for seven years or more, it is unlikely that you would face such problems. So now we return to the three key issues.
In your case, a new mortgage might be as much as 2.5 percentage points below your current rate. In the past, the traditional rule-of-thumb called for a least a two-percentage point difference between the old and new rates before a refinancing made sense. Now, because the refinancing costs can be spread out over the life of the loan, experts have modified their advice. A refinancing can make sense with as little as a 1 to 1.5 percentage point difference between the old and new rates.
What will a refinancing cost? It depends on your lender and the size of your loan, but you can expect total costs to run as much as 3% of the amount you are borrowing. In your case, let’s estimate that your refinancing costs would be as much as $2,100 for a $70,000 loan. By refinancing your loan at a 7.5% interest rate, your annual mortgage savings would be in the neighborhood of $1,500, allowing you to recover your costs in about 16 months. So if you plan to live in the home for at least another two years, you would be money ahead by refinancing.
The pay-back period increases as the difference between the two mortgage rates narrows. This is where the you must factor in how much longer you intend to own your home. Traditionally, experts have recommended refinancing only if you expect to stay put for another five years. However, as the above example demonstrates, sometimes benefits are realized far sooner.
There are other reasons for refinancing beyond immediate mortgage savings. Some homeowners now holding adjustable-rate mortgages might want the security of a fixed-rate loan and be willing to pay a premium up front for the knowledge that their mortgage payment will remain set for the life of the loan.
Adjustable-rate mortgage holders might consider refinancing to another adjustable loan to lock in more favorable terms, such as a lower interest rate ceiling.
Still other homeowners might want to refinance from a 30-year mortgage to one that runs for just 15 years, a move that would likely result in a larger monthly payment but a far lower interest payout over the mortgage term.
With real estate sales remaining depressed throughout much of the nation--and especially here in Southern California--lenders have come to rely on refinancings as a major source of business. This presents a mixed blessing for consumers who are willing to do their homework and shop around for the best loan. On the plus side, lenders are very competitive and are willing to deal. On the minus side, unscrupulous lenders and mortgage brokers can cash in on the “refinancing mania” that typically accompanies another interest rate drop to persuade homeowners to refinance a perfectly good loan.
Consumers should also beware of deals that seem “too good to be true,” such as extremely low first-year teaser rates and loans that must be refinanced after just a few years. More than one homeowner has been victimized by brokers and lenders who get them a loan that must be redone, at substantial cost, long before the homeowner has realized any benefit.
Minnesota’s attorney general has prepared a consumer guide to mortgage refinancing. Although it contains references to Minnesota law, its advice is generally applicable to homeowners throughout the nation. In addition, it contains work sheets consumers will find helpful in shopping for and comparing loans and calculating whether a refinancing makes sense.
The booklet is available for $2 to cover shipping and handling by writing to Atty. Gen. Hubert Humphrey III, State Capitol, St. Paul, Minn. 55155. Make the check payable to the State of Minnesota.
