No Time Like the Present to Save by Refinancing Your Mortga
- Wednesday, February 26, 2003
I refinanced my house mortgage in late 2001, and by the following August, I gave the go-ahead to do it again. Rates have continued to fall this year, making such a move profitable for me and millions of other homeowners—like you!
Refinancing your mortgage, in order to take advantage of lower interest rates and/or shorten your payment schedule to a fifteen-year maturity, can result in significant savings on interest expense.
Refinancing involves paying your existing mortgage off early by taking out a new one at a lower rate. The key statistic in deciding whether to refinance is learning how far down the road you "break even." Here's what you do. First, understand what "points" are. A typical mortgage loan, in addition to the interest rate you pay, carries one "point." A point is equal to 1% of the loan amount and is charged by the lender to cover the up-front costs of originating the loan, appraisals, title search, legal fees, and so on. These points are subtracted from your proceeds at the time of your loan closing. For example: If your new mortgage is for $120,000 and you are charged one point, then you really only receive credit for $118,800 at the loan closing ($120,000 times 1% equals $1,200 in points paid).
Next, shop for the best deal and learn (1) what your total closing costs will be (excluding any pre-payments for insurance, taxes, or interest) and (2) what your new monthly "principal and interest" (P&I) payment will be. Finally, subtract the amount of your new P&I payment from your old one. This tells you how much you'll save each month. Then divide this monthly savings into your closing costs. This tells you how many months before the refinancing pays for itself (tax considerations aside). That's your break-even point; after that, you're saving every month.
Here's an example: If your new monthly payment would be $140 less than your current one, and if your total closing costs (including one point) were $2,800, then it would take twenty months' worth of savings to pay your expenses (2800 divided by 140). After that, you'd be ahead an extra $140 each month.
It can get confusing trying to compare different proposals, so here's a handy way to convert points into a percentage rate: treat each point as if it added ¼ of 1% to your loan rate. Example: a 6% rate with one point is roughly the same as a 6¼% rate with no points.
Once you know the break-even point for each loan you've been quoted, the main consideration is how long you expect to be in your present home. If you don't think you'll be there long enough to reach the break-even point, forget it. If you think you'll be there past break-even and decide to go ahead, you still have to decide whether to take a loan that features a lower rate but more points, or a higher rate with fewer points. The general rule is that the shorter the time past break even that you expect to live there, the more you should lean toward the lower transaction costs. That means a shorter stay equals fewer points with a higher rate; a longer stay equals more points but a lower rate.
To keep things simple, many lenders offer a "no points or closing costs" option where they let you skip the points and closing costs entirely in exchange for a higher interest rate. Then it becomes simply a matter of comparing the interest rate they quote you with the rate you're paying now. For example, if you're currently paying 7.00% but can get a "no points or closing costs" rate of 6.50%, you're guaranteed to save. In fact, there's no reason you wouldn't want to refinance many times over the years when the advantages are this clear cut. Sure, there's some paperwork involved, but there's probably nothing else you can do that will pay you (in saved interest) such a high hourly rate for your time! I'd check every ninety days, and consider refinancing whenever you can save at least one-quarter of a percent on a "no points or closing costs" basis. Depending on the overall level of rates, you'll save $6,000–$7,000 in interest over thirty years on a $100,000 mortgage for every one-quarter percent reduction in your rate. However, the shorter the remaining term of your mortgage, the less you will save. With under ten years remaining on a thirty-year mortgage, it is unlikely that refinancing will result in much savings.
Here are some other shopping tips that can help you save money. First, look into getting a fifteen-year mortgage rather than a thirty-year one. The monthly payment will be higher, but the interest rate is lower. The savings in interest is dramatic!
Second, if you refinance and end up with a lower monthly payment than you're now making, the temptation will be to take the savings and spend it elsewhere. Don't do it! Instead, send in the same amount using two checks. One check will be for the new monthly payment; the other can be applied to pre-paying principal and hastening the day when you own your home free and clear. Be sure to include a note explaining that the extra payment is to be applied to the principal balance.
Other things to keep in mind:
- You can refinance with the original lender or go to a new one.
- Find out when the rate on your loan will be "locked in" (permanently set). Is it when you apply? When the loan is closed? Many borrowers have been hurt when interest rates rose after the original proposal was made but before the lender locked in the rate.
- Get a commitment in writing of the exact terms of the mortgage being offered and how long the offer is good for. It should include the circumstances under which the lender would be allowed to back out (for example, in case of a dispute over the appraised value of your home).
- Check with your loan officer or processor to find out when the appraisal and credit agency reports are due back. Call on the expected dates to see if everything checks out.
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