Refinancing Your Home ZillowLogo

You have an Adjustable Rate Mortgage (ARM) which was doing fine enough that you bragged about it – but now interest rates seem to be on the upswing, with the Fed raising rates and everyone buzzing about it. Lying awake at night is interfering with your job, so you figure you'd better say goodbye to that low – but fluctuating – interest rate, and get a nice secure fixed-rate loan before the swing hits the sky.

This is a common scenario these days as interest rates inch up and many homeowners who opted for ARMs in the past ten years are beginning to talk about switching from the flexible ARM to a traditional loan.

Switching types of mortgages, as above, is one reason to get a refi, which is simply replacing a current mortgage with another. But there are others: 

     - Lower your interest, but keep your term: When rates drop you want to take advantage of it and lower your monthly payments, but keep the length of your mortgage

     - Take care of that balloon payment: You opted for a short-term ARM with a balloon payment and the due date is looming, so you have to come up with a longer-term loan.

     - Shorten your term: Lower interest rates (or an increase in your income) mean you can pay down your principle faster.

     - Credit rating change: Take advantage of an improved credit rating and get out from under that high rate you had to accept when you bought.

     - You need cash: In some cases, you can refinance for an amount more than what you still owe on your home. Lenders limit the Loan to Value - at no higher than 70 percent for this type of loan.

Most of the things – fees, appraisals, title insurance – that went along with an original mortgage hold true for a refi, which means it can cost a fair amount to change loan types. How quickly you recoup the cost depends partially on how long you are going to keep the mortgage. If you are going to be in your home long enough to recover the costs, and get some benefit from lower interest payments over the life of the loan, then it's a no-brainer. But balancing the cost with the benefits of a new mortgage is critical. And pretty easy to do. Check out these two companies for calculators to help:
Mortgage 101 and Bankrate.

Be sure to remember that closing costs include another appraisal (no matter how recently you've had one), a new credit report, underwriting fees, title insurance, escrow fee, recording fees, and perhaps other small fees. These costs typically range from $1500-$2000. (Some lenders are willing to waive the closing costs for a higher interest rate loan)

You can pay points on a refinance loan, same as on an original mortgage, but unlike with the original mortgage, the points are tax deductible over the entire term of the loan. Points make sense when rates are on the upswing and you want to get in on the lowest possible rate.

But, except in some cases, points are a fact of life: if you are paying a 1-point fee on a $100,000 refi, you can add $1000 to your closing costs.

You also need to look at your current mortgage to see if there are pre-payment penalties. And what happens to your old mortgage? It's paid off by the new loan, as are any other liens; at the end of the refinance process, ideally you should have only one loan. (If you have more than one mortgage, however, it's possible to refinance just one of the loans if the lender agrees.)

The easy way to figure out if refinancing makes sense is to figure out how long it will take you to pay off the closing costs with the savings you realize with lower monthly payments. If it is longer than the time you plan to stay in the house, then refinancing might be a good option. You have fewer tax breaks with a lower-rate refi, so be sure to ask your lender for a refinance break-even table that will take that into account.

Real Life Example

Greg has owned his home for five years. He expects to stay in it for another 10 years, until his kids are on their own and he can buy his dream RV. He has another 25 years to pay off his current 8 percent mortgage of $150,000. His payments are $1101 per month. He's found a 6 percent mortgage, which would lower his payments to $900. He sure could use that extra $200 a month. But it is costing him a total of $2500 in closing costs to refinance. And when he considers his current tax benefits (he's in a 28-percent tax bracket), he is actually only saving $166 a month. He looks at the $2500 cost, and divides that by his savings and figures it will take him 15 months – a little over a year – to break even. Since some of his closing costs are tax deductible too, he feels pretty good about this.

Related links: Home Equity Loans and Lines; Choosing a Lender; Types of Lenders