Make Sure You Won’t Lose Money When Refinancing

Will you live in the home long enough to absorb the up-front costs of refinancing?

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Some people never think about their mortgage after getting it, except to write a monthly check and claim the tax deductions. Others watch the mortgage interest rates like hawks and refinance every time the rates take a dip. The safest course is somewhere in the middle.

Done wisely, refinancing can be one of those, “Whoa, I just earned tens of thousands of dollars for a few hours of work!” tasks. But done blindly — without paying attention to the fact that every new mortgage costs you upfront fees and possibly points, and stretches your loan back to a full 30 (or however many) years of interest payments — refinancing can actually lose you money.

When should you consider refinancing? You might have heard an old rule of thumb that, for fixed-rate mortgages, the time is right when interest rates have dropped by two percentage points since you got the loan (for example, from 7% to 5%). But that theory dates from a time when closing costs were consistently higher than they are now and tended to undo the benefits of refinancing.

So you’d do best to run the numbers, as described below, even if the interest rate drop is as low as 0.5%.

Another good time to refinance is if you are tired of the fluctuations in your adjustable-rate mortgage and want to switch to either another ARM with better terms or to a fixed-rate mortgage.

In any case, you will need to take two important steps before deciding whether to refinance:

  • find out how much a refinance will cost you up front, and
  • calculate your total savings.

As with your original mortgage, you should also shop around, both with your current mortgage company and by comparing rates online and with local lenders. A good mortgage broker can help you with this, as well. Also watch out for prepayment penalties on your current mortgage. Technically, when you refinance, you pay off your existing mortgage — meaning you’d also have to fork over any prepayment penalty fees.

How Much Your Refinance Will Cost Up Front

Although refinancing can save you thousands of dollars over the life of your loan, transaction costs can significantly reduce these savings.

You’ll recognize many of these transaction costs: They’re similar to the ones you paid when you first bought your home. Examples include title insurance and escrow fees, lender service fees, points (if you choose to pay them in return for a reduced interest rate), appraisal fees, credit reporting fees, and so on. Why, then, do you have to pay them all over again?

The reason is that your new lender wants to hear for itself that if you don’t make your mortgage payments, it can sell your house for enough money to cover what you still owe on your loan (the outstanding balance).

Ask your prospective lender or mortgage brokers about how to keep transaction costs down. A lender who wants your business might agree to waive certain fees, such as document preparation and processing costs. And some lenders skip the appraisal if you bought the house fairly recently or you have so much equity in the property that they’re all but guaranteed to get their money back in a foreclosure.

Title insurance is another area where it’s possible to reduce costs when refinancing. You might, if it’s been less than ten years since your title insurance policy was issued, be able to get the policy reissued, or have a “quick” title search done in preparation for the new policy. A quick search basically looks only for issues that have popped up since you became the home’s owner. Using the same title company as you did when you first bought the house will help with this.

After all these warnings, your ears may perk up when you hear advertisements for “no-cost” mortgages, promising zero closing costs. But these usually charge comparatively high interest or roll your closing costs into the loan amount, so that you pay the same costs eventually. That said, one good time to go for a no-cost mortgage is if you plan to stay in your house for only a short while, in which case you won’t have time to save much on interest, but will have saved a lot on the closing costs.

Your willingness to pay a share of the standard, reasonable costs, and perhaps points, should make you eligible for a competitive interest rate. Just pay close attention and watch out for unexpected or extra-high fees as the process goes along. The best way to do this is to compare the Good Faith Estimate (GFE) of your costs that the lender will give you when you first apply to refinance, and compare that to the actual amount you’re required to pay at closing. And, as discussed below, figure out how the closing costs and the interest rate will balance each other out over time.

Calculating Whether the Savings Will Be Worth the Costs

Never just calculate what your new monthly payment would be after a refinance and say, “Great, it’s lower than our current monthly payment, let’s do it!” Even assuming you’re comparing apples to apples (such as a fixed-rate 30-year mortgage to another fixed-rate 30-year mortgage) you’d be leaving out one vital fact: Starting over with a new 30-year mortgage means adding several months or years to your payment schedule. Thought your mortgage would be paid off by the time you retire? You may have just nixed that hope. And the more time you take to pay, the more interest you’ll owe in total.

If your math anxiety is starting to kick in, don’t worry; online calculators can help you. To compare fixed-rate mortgages, see Zillow’s “Should I refinance my home mortgage?” calculator. Another good resource is the "Tri-Refi Calculator" set at hsh.com, which lets you compare a cash-out Refinance with a no-closing cost or traditional refinance.

To calculate whether to switch from an ARM to a fixed-rate mortgage, see the Mortgage Professor’s “Refinancing an ARM into a FRM to Lower Risk” calculator.

These calculators ask you to input data such as your existing loan balance and terms, how long you have left to pay off your mortgage, any upfront costs and points to refinance, and the new interest rate. You’ll then find out your new monthly payment amount, your total interest savings, and your “breakeven point.”

The breakeven point is especially important. It means the number of months or years it will take you to work off your initial closing costs by saving on interest each month. If you think you’ll stay in your home for less time than it takes to reach your breakeven point, the refinance definitely isn’t worth it. But if it’s likely you’ll stay long enough to work off these costs, refinancing may be the ticket to reducing your homeownership expenses.

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