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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.
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Refinancing
Considerations
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When you're making
your decision, there are several things 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.
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Consider
Other
Mortgage Programs
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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. |
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Mortgage
Refinancing
Costs
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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.
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Paying Points
for a Lower
Rate
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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.
Analzying 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. |
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Analyze
Your Savings
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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.
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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. |
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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 Joe Smoley,
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. |
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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. |
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Your
Personal Income 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. |
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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. |
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