In recent years, Americans seeking to take advantage of low
interest rates have lined up to refinance their mortgages -- often
resulting in significantly lower monthly payments.
But while it's true that refinancing has the potential to help
you reduce the costs associated with borrowing money to own a home,
it is not necessarily a strategy that makes sense for every
individual in every situation. So before you make a commitment to
refinance your mortgage, it's important to do your homework and
determine whether such a move is the right one for you.
To Refinance or Not
The old and arbitrary rule of thumb said that a refi only makes
sense if you can lower your interest rate by at least two
percentage points -- for example, from 6% to 4%. But what really
matters is how long it will take you to break even and whether you
plan to stay in your home that long. In other words, make sure you
understand -- and are comfortable with -- the amount of time it
will take for your overall savings to compensate for the cost of
the refinancing.
Consider this: If you had a 30-year $200,000 mortgage with a
6.5% interest rate, your monthly payment would be $1,264. If you
refinanced at 4.5%, your new monthly payment would be $1,013, a
savings of $251 per month. Assuming that your new closing costs
amounted to $2,000, it would take eight months to break even ($251
x 8 = $2,008). If you planned to stay in your home for at least
eight more months, then a refi would be appropriate under these
conditions. If you planned to sell the house before then, you might
not want to bother refinancing. (See below for additional
examples.)
Remember -- All Mortgages Are Not Created Equal
Don't make the mistake of choosing a mortgage based only on its
stated annual percentage rate (APR), because there are a variety of
other important variables to consider, such as:
The term of the mortgage -- This describes the
amount of time it will take you to pay off the loan's principal and
interest. Although short-term mortgages typically offer lower
interest rates than long-term mortgages, they usually involve
higher monthly payments. On the other hand, they can result in
significantly reduced interest costs over time.
The variability of the interest rate -- There
are two basic types of mortgages: those with "fixed" (i.e.,
unchanging) interest rates and those with variable rates, which can
change after a predetermined amount of time has passed, such as one
year or five years. While an adjustable-rate mortgage (ARM) usually
offers a lower introductory rate than a fixed-rate mortgage with a
comparable term, the ARM's rate could jump in the future if
interest rates rise. If you plan to stay in your home for a long
time, it may make sense to opt for the predictability and security
of a fixed rate, whereas an ARM might make sense if you plan to
sell before its rate is allowed to go up. Also keep in mind that
interest rates have hovered near historical lows in recent years
and are more likely to increase than decrease over time.
How Much Would You
Save? A homeowner with a 30-year, $200,000 mortgage
charging 7.5% interest would pay $1,398 each month. The table below
illustrates the potential monthly savings and the various
break-even periods that would result from refinancing at different
rates. |
Rate After Refinancing |
New Monthly Payment |
Monthly Savings |
Months to Break Even* |
6.0% |
$1,199 |
$199 |
10 |
5.5% |
$1,136 |
$263 |
8 |
5.0% |
$1,074 |
$325 |
6 |
4.5% |
$1,013 |
$385 |
5 |
4.0% |
$955 |
$444 |
5 |
3.5% |
$898 |
$500 |
4 |
*Assumes $2,000 closing costs. Rounded up to the
next highest month. |
Points -- Points (also known as "origination fees" or
"discount fees") are fees that you pay to a lender or broker when
you close the deal. While a "no cost" or "zero points" mortgage
does not carry this up-front cost, it could prove to be more
expensive if the lender charges a higher interest rate instead. So
you'll need to determine whether the savings from a lower rate
justify the added costs of paying points. (One point is equal to
one percent of the loan's value.)
A Closer Look at Mortgage
Fees*
Mortgage-related costs that may apply to your loan could include
the following items. Source: Bankrate.com |
Application fee |
$75-$300 |
Loan origination fee |
Up to 1.5% of loan principal |
Points |
0-3% of loan amount |
Appraisal fee |
$300-$700 |
Home inspection fee |
$175-$350 |
Legal and closing fees |
$500-$1,000 |
Title search and insurance |
$700-$900 |
Survey fee |
$150-$400 |
Prepayment penalty |
Will vary according to terms of mortgage |
*Other settlement costs may also apply. |
Stick With What You Know?
Finally, keep in mind that your current lender may make it
easier and cheaper to refinance than another lender would. That's
because your current lender is likely to have all of your important
financial information on hand already, which reduces the time and
resources necessary to process your application. But don't let that
be your only consideration. To make a well-informed, confident
decision you'll need to shop around, crunch the numbers, and ask
plenty of questions.