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"Enjoy your own life without comparing it with that of another."
-Marquis de Condorcet
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Home Refinancing Basics
In recent years, millions of homeowners have taken advantage
of low rates and refinanced their mortgages. This article
describes the advantages and possible pitfalls associated
with a "refi."
Home Refinancing Basics
In recent years, Americans seeking to take advantage of
low interest rates have lined up to refinance their mortgages.
In fact, refinancings hit an all-time high in 2003, and
remained high in both 2004 and 2005, according to the Mortgage
Bankers Association of America.
However, 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, its 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 9% to 7%. 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 $200,000 30-year mortgage with
an 8% interest rate, your monthly payment would be $1,468.
If you refinanced at 6%, your new monthly payment would
be $1,199, a savings of $269 per month. Assuming that your
new closing costs amounted to $2,000, it would take eight
months to break even. ($269 x 8 = $2,152). 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 hovered near historical lows in recent years
and are more likely to increase than decrease over time.
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.)
| How Much Would You Save? |
| A homeowner with a 30-year, $200,000 mortgage charging 8% interest would pay $1,468 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* |
| 7.5% |
$1,398 |
$70 |
29 |
| 7.0% |
$1,331 |
$137 |
15 |
| 6.5% |
$1,264 |
$204 |
10 |
| 6.0% |
$1,199 |
$269 |
8 |
| 5.5% |
$1,136 |
$332 |
7 |
| 5.0% |
$1,074 |
$394 |
6 |
| *Assumes $2,000 closing costs. Rounded up to the next highest month. |
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.
Summary
- The decision to refinance should only be made if the long-term savings outweigh the initial expenses. To calculate your break-even point, divide the cost of the refi by your monthly savings. The resulting figure represents the number of months you will need to stay in the home to make the strategy work.
- Don't select a new mortgage based only on its annual percentage rate.
- Also evaluate the term of the loan, whether the interest rate is fixed or variable, and the relative merits of paying up-front fees in exchange for a lower rate.
- Your current lender already knows you and has your financial information on file, so you may be able to get a better deal that way, instead of going to a new lender.
- To get the best possible refinancing deal, you'll need to shop around, crunch some numbers, and ask a lot of questions.
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