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Introduction The rule widely published years ago was to only refinance if you could lower yourmortgage interest rate by at least two percentage points. This general rule of thumb was asimple way to analyze the refinance, allowing consumers to consider the rough costs ofrefinancing. That rule no longer holds true in today's market, because you can refinanceyour mortgage or no closing costs, or no points. When a refinance costs you nothing, anysavings in the rate is pure gravy. ``No-Closing Cost'' refinances are just one of the ``2%rule'' breakers. We'll discuss these and other reasons to consider refinancing in thisarticle.
Here are some of the most popular reasons to refinance:
``No Closing Cost'' Loans Any loan where the lender pays all of your closing costs (like title & escrow fees,appraisal, lender's fees, etc.), is commonly referred to as a ``no-cost'' loan. A true``no-closing cost'' loan differs from both a ``no lender fee'' loan or a loan in which thelender adds the closing costs to the amount financed. A ``no lender fee'' loan, sometimesadvertised by banks, usually will not cover the title, escrow, and other outside chargesyou may need to complete the refinance. With a true ``no-closing cost'' loan, you can refinance for any incremental drop inyour interest rate since the transaction costs are zero. Even in a declining rate market,where you believe rates may continue to fall, a no-cost loan will make sense. Should ratescontinue to decrease you will have invested nothing in the loan costs, and can simplyrefinance at any time. Some borrowers refinance every year or less! No cost loans will always carry a slightly higher rate than a loan that does not payyour costs. In general, a no cost loan is the better strategy if you plan to keep yourloan for the next two and a half to three years. Longer than that, you should considerpaying the costs yourself to get a lower rate. Over time, the lower rate will save youmore money. And if you plan to keep the loan for four to five years, it often makes senseto pay points to get an even lower rate.
Lower your Monthly Mortgage Payment One of the most common reasons for refinancing is to lower the monthly payment. Theanalysis here is simple. Ask your mortgage source what the costs involved are (all costs,not just the lender's fees). Verify this by asking what loan amount the new payment isbased on. Then take the cost of the refinance and divide by your monthly savings todetermine the ``break-even'' point in time. As long as you plan to keep that loan for sometime longer than the break-even point, it's advantageous to refinance. Even with a loan that includes costs, at times it may make sense to lower your paymentby wrapping the costs into the new loan balance. Just be aware that the costs areincreasing your principal balance owed and still do the analysis above. By following thisstrategy of increasing your mortgage balance, you are borrowing against your home'sequity. Of course with a no cost refinance, the break-even is immediate since you are reducingyour payments without investing in the closing fees or increasing your outstanding loanbalance.
Sample Analysis Let's assume that your original loan was for $200,000 and your interest rate is 8.0%,with payments of $1,469.21. Perhaps you've had the loan for 3 years and the balance ispaid down to approximately $194,500. After talking to a mortgage source, you are quoted7.75% with payments of $1,409.51. ``Why, that's a savings of almost $60/month'' they tellyou. But what about the closing costs? Remember to ask if there are any costs, and if so,how are they paid? By the lender or will they be included in the amount financed? We'llshow you how to make the right decision. In this example, the lender is proposing to include the $2,000 in closing costs intothe new loan balance of $196,500. At 7.75% the new loan will give you a lower payment, butit is still worthwhile to consider the costs that are being financed. While the payment islower than your current loan, you must also keep in mind that the loan period is beingextended by stretching the larger loan balance out over a new 30 year term. In this example, with a savings of approximately $60 per month, recouping the closingcosts will take 34 months, which is explained in the table below. In this current interestrate market, you should be able to keep your break-even point at 24 months or less. Try adifferent mortgage, look for lower costs, or monitor the market until rates improveslightly.
Switch from an Adjustable Rate Mortgage (ARM) to a Fixed Rate Loan Has your adjustable (ARM) moved up on you in the last few years? Don't feel likestarting with another low rate and watching it move up all over again? Considerrefinancing into the security of a fixed rate loan but remember that all fixed rate loansare not the same. Today's market offers numerous choices for loans that are fixed for a shorter time thanthe traditional 30 or 15 years. Loans are available with fixed rates for 3, 5, 7, and 10years and the shorter the initial fixed period, the lower the interest rate. All of theseloans are amortized over 30 years so there's no need to worry about the payment being toohigh. All you need to do is match up how long you expect to keep the loan with the closestfixed term. This may be shorter than how long you plan on keeping your home, if you feelcomfortable with the refinance process. At the end of the fixed term, these loans automatically convert into ARMs withadjustments annually, so there is no balloon payment. TIP: As the market shifts arounddaily and weekly, you might be able to get a 7 year near the cost of a 5 year, so keepyour eyes on both. Often the current fixed rates will be somewhat above the rate on your current ARM,unless you are several years into your adjustable. You will need to decide if the securityand insurance against further rate increases is worth the additional payment that youmight incur.
Switch from a Fixed Rate Loan to an Adjustable Rate Mortgage (ARM) OK, you're probably wondering what's going on. One minute we suggest getting out of anadjustable, and then turn around and suggest you go into an adjustable. But it really canmake sense in some situations. If you've recently decided to start looking for a new home, or will be relocatingwithin the next few years, it may make sense to evaluate your current loan. By switchingfrom a 30 year fixed to a low rate adjustable or short term fixed, such as a 3 Year Fixed,you can save substantially over the remaining time that you'll be in your home. In thistype of situation it almost never makes sense to pay closing costs, so shop for a no costloan with a slightly higher rate. Also, don't take a loan with a prepayment penalty,unless the prepayment is waived upon sale of the home. This strategy can be best explainedby showing an example. For simplicity, we're assuming that your loan balance is the sameon both the refinance and original loan.
Take cash out of your home The primary advantage of home mortgage loans is that the interest costs are deductiblefor tax purposes. If you are currently paying a higher rate of interest on credit cards,car loans, or other forms of debt that are not deductible, it may make sense to pull thecash out of your home (provided that you have the equity) and use it to pay off thoseother debts. Lenders will typically allow you to borrow up to 75% of the appraised value of yourhome in a cash out refinance. (Some lenders will go up to 80%, however the loans offeredwill be less competitive than at 75%.) Paying off other bills or credit cards, buying anew car, sending the kids to college, investing in an Internet start-up, or buyingadditional real estate are all good reasons to refinance your home and take cash out. Even if you're able to keep you credit card interest rate at 8-9% with low introductoryoffers, when you consider the tax savings of your mortgage interest, you will be payingless interest if those balances were part of your mortgage instead. If you are paying 8%on your mortgage and your tax bracket is 33%, your net interest rate is 5.3% which isstill less expensive than any credit card program over time.
Eliminate Mortgage Insurance (MI) If you purchased your home with less than 20% down, chances are you have a loan that isinsured by ``Mortgage Insurance'' (MI). Most borrowers are aware that they are paying MIon a monthly basis, but you can check your mortgage statement if you're not sure. As yourhome appreciates or your loan balance decreases (or a combination of the two), your equityin the home will exceed 20%. At that time a favored method of eliminating the MI tied tothe loan is to refinance. The savings of eliminating the MI alone will often warrantrefinancing. Be aware that mortgage lenders value your property at what comparable homes have soldfor in the last 6 months, not what they are currently listed for. If you are close to that20% mark, ask your mortgage source to provide you with a ``comp search'' estimate (thisservice should be available for free) which will give you an idea of how your lender willview your home's value. If you are currently in a low rate fixed mortgage, don't refinance simply to remove MI.Instead, work with the existing mortgage holder so that you can keep that low rate andstill reduce your payment by removing the mortgage insurance premium. Since the lenderdoes not have as strong an incentive as you to eliminate the MI portion of your payment,there sometimes appears to be an unwillingness to assist in this process of removing themortgage insurance. Do not be discouraged by the lack of information or cooperation if youdo encounter some resistance. Request in writing the lender's policy on eliminating MI andwork with the lender until they have satisfied you.
But I Don't Want to Extend my Loan Term! On a final note, some people hold on to their loans simply because they do not want toextend the remaining time that they'll be paying on a mortgage. If you are five years intoa 30 year fixed loan, with 25 years remaining, how can you be certain that you're makingthe right choice by refinancing into a lower rate? Doesn't the fact that you'repotentially extending your loan term wipe out the potential savings of the lower rate?Absolutely not! The simplest way to prove this is to take the new loan, and amortize it over theremaining term of your current loan. That is, assume that you still want to pay off yourloan in 25 years, and then calculate what your payments need to be to make this happen.Now compare your total payments with the new lower rate mortgage versus your existingloan. If your total payments over the remaining term are lower this means that you'repaying less interest, and it makes sense to refinance. Since all lenders will accept anadditional payment towards principal on a monthly basis, you can be certain that your loanwill get paid off on time and you'll save on interest costs. Let's let the numbers speakfor themselves.
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