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Refinancing Your Mortgage

Mortgage rates on 15- and 30-year fixed mortgages are at all-time lows. So, is now a good time to refinance your existing mortgage? That depends on several factors.

The first, of course, will be your loan-to-value ratio. In no-cash-out refinancing (where the amount of your new loan doesn’t exceed the balance of your existing loan, plus points and closing costs, if applicable), you may be able to borrow as much as 95% of your home’s value. However, if the value of your home has fallen below the amount of your existing mortgage balance, you may be unable to refinance at all, except through the American Recovery and Reinvestment Act of 2009’s Home Affordable Refinance program (see sidebar). But let’s assume your loan-to-value ratio is still “above water”–that is, the value of your home is still greater than your mortgage balance.

If you refinance your mortgage to a lower interest rate, you may save a substantial amount on your monthly mortgage payment–which will give you more money to put toward your savings goals or reducing your other expenses. This is one of the main reasons people consider refinancing their mortgages. But what other factors do you need to consider?

How much will it cost?

The cost of refinancing can include both points you pay and other expenses (called “closing costs”) related to refinancing.

One point equals 1% of the amount to be financed. So, if the refinancing costs will include an up-front charge of 0.5 points and you’re refinancing $200,000, you will incur a charge of $1,000 (special tax treatment applies to points).

Closing costs typically include an application fee, attorney’s fee, appraisal fee, credit report fee, loan origination fee (which can be 1% or more of the amount you refinance), title search fee, and title insurance. These costs can vary from state to state. Get a “good faith estimate” from each potential lender and compare both closing costs and interest rates.

Be careful about lenders that advertise “no points, no closing costs” refinancing deals. Often these plans simply roll the closing costs into the amount to be refinanced, or come at a higher interest rate.

How long will it take to recoup the costs?

To determine your break-even point (the point at which you’ll begin to save money after paying fees and closing costs), divide the amount of your monthly mortgage payment savings due to refinancing into the cost of refinancing; the result is your break-even point, expressed in months.

Example: If you’re saving $100 per month on your refinanced monthly mortgage payment, and your refinancing costs totaled $3,700, your break-even point is in 37 months.

It makes sense to refinance if you’re certain that you’ll be able to recoup your refinancing costs while you’re still living in your home. Ideally, you should recover your costs in one year or less.

A matter of term

In many cases, refinancing may mean taking out a mortgage with a new term equal to the original term of your refinanced mortgage, not equal to the remainder of the term on that mortgage. Depending on when you refinance, this can make a significant difference in the amount of interest you’ll pay overall.

Example: You have a $200,000 30-year fixed mortgage at 6%, with a monthly payment of $1,199. After 6 years, you have paid $69,131 in interest on that mortgage. At that point, you refinance your remaining principal balance of $182,796 for a new 30-year fixed mortgage at 5% with a monthly payment of $981. Over the life of that new mortgage, you will pay $170,468 in interest. So, your total interest payment will be $239,599 ($69,131 + $170,468). If you had stayed with your old mortgage at 6%, you would have paid a total of $231,676 in interest. Instead, by refinancing when you did, you’ll pay an extra $7,923 ($239,599 – $231,676) in total mortgage interest.

Because of this, you may want to consider applying the monthly mortgage payment savings after refinancing toward additional principal payments. By doing so, you can reduce both the term of your mortgage and the total interest you’ll pay.

Crunch the numbers first

In many cases, refinancing looks attractive in the short term because your monthly mortgage payment will be lower–and that can be important to your monthly budget. But will it really save you money to refinance, both in the short run and in the long run? That depends on many factors. Look at them all before you make your decision.