Mortgage interest rates are ticking down and refinancing is suddenly hot again. Make that Scorching Hot! A few years back when mortgage rates first dropped into the 5s, mortgage refinancing was the hot topic anywhere people gathered. It might not seem like the most scintillating party conversation, but this was a prime conversation as people vied for bragging rights on who was able to get the lowest interest rate. (Or maybe I just went to the wrong kind of parties.) Mortgage rates are back in the mid 5s again, and this time there isn't the same level of excitement in the air. But it is a great time to take advantage of the low rates, improve your financial situation and put some extra money in your pocket
Why should you consider refinancing?
- You can lower your interest rate and payments.
- You can shorten your loan term and pay your mortgage off early.
- You can take cash out for home improvements, college expenses, investments, or whatever your needs may be.
- You can restructure your debts with a refinance to get rid of your high interest credit card balances and save hundreds of dollars per month.
- If you bought with a low down payment, you can often refinance to get rid of mortgage insurance or your higher rate second mortgage.
You can get rid of an adjustable mortgage and lock in to a fixed rate.
These are just a few reasons you may want to take on a new mortgage. It is important, though, to make sure you know why you are refinancing and that it is really in your best interest.
For a quick check to see if refinancing makes sense for you, you need to consider 3 things:
How much will you save by refinancing?
How much will it cost to refinance?
How long do you expect to stay in the mortgage?
There used to be a rule of thumb that said that the interest rate needs to go down by 2 percentage points before it makes sense to refinance. This is no longer the case. The process has been streamlined, and closing costs are usually much less, at least here in Illinois where title costs are reasonable. So it may make sense to refinance even if you are only reducing your interest rate by a relatively small amount. (There have been periods when the rates were dropping, where I refinanced the same customer 3 times in a year, and they benefited more each time.) To find out you need to figure out your payback or break-even point. Let me work through the math to show you how this works.
The first step is to determine how much you will save. For an example, let's assume that you now have a mortgage with a $200,000 balance and a 6.75% interest rate. This would give you a payment of $1,297 per month. Let's say that rates have improved, and you can now get the same type of mortgage for 5.75% with a payment of $1,167 per month. This is a savings of $130 per month. Does it make sense to refinance? Maybe. We still need to know more, though.
The next thing you need to know is how much it will cost to refinance. This is where it gets interesting. If you have spent any time on the Internet, you've seen lots of ads for mortgage companies claiming they offer the lowest rates. But low rates don't mean a thing if you don't look at the closing costs too. I've seen closing costs vary by as much as $6,000, so this is something that can make a huge difference. Closing costs include title fees and the amount the bank charges to process the loan, which includes fees for credit reports, appraisals, processing and underwriting charges as well as Points which are upfront financing charges.
To see how the closing cost can make the difference, let's assume that the cost to refinance is $1,600. If you are saving $130 per month and it cost you $1,600 to close, that means it will take you just about a years worth of mortgage savings to pay off the up-front costs. Every month after that will be a true savings. If that same loan cost $6,000 to close, then it would take 4 years before you would have any benefits from refinancing. So the lowest rate isn't always the best deal.
The next part is figuring out how long you expect to be in the mortgage. If you plan to stay in the home for at least 10 years, and you don't expect that interest rates will drop much lower than they are, then paying more to get a better rate might be the best strategy. Most people will either move or refinance sooner, though. The average 30 year mortgage is paid off in about 5 years. If you are like most people, you would be better served by getting a loan with lower closing costs. Even though the rate and payment may be a little higher, your savings will come quicker.
Things to watch out for- The idea that the lowest rate is the best deal can be a big problem. A few years back when we were in a huge refinance boom, one of my clients talked with a friend who boasted about the great deal she got, a rate below anything available on the market. My client called and she wanted the same rate as her neighbor was getting. I did a little research and found out that her neighbor was paying 3 points to buy down the rate. On a $300,000 loan that comes out to $9,000 in extra closing costs! A low rate is great, but it's not going to help you if you have to pay so much extra to get it. Which brings up our next point. Refinancing doesn't have to cost a lot.
No/Cost refinancing - When rates are down, the biggest obstacle to homeowners lowering their payments and taking advantage of the low rates is the cost of refinancing. The more that the loan costs, the longer you will need to be in the new loan before refinancing makes sense. So if a loan costs a lot up-front, it takes a big improvement in the rates before it is worth doing. On the other hand, if there are no costs at all, a small reduction in the rates can save you a lot of money over time.
Some people say there is no such thing as a true no-cost refinance. It does cost money to refinance, and it's true, the lender and title company are going to be paid, one way or another. With a no-cost refinance we use the yield spread premium (the money that the lenders pay the mortgage broker or banker to bring them the loan) to pay for the closing costs. When I price loans I have several different options. Every day the lenders we deal with send us new price sheets. These sheets have matrices which allow us (the mortgage banker or broker) to price the loan in different ways. It is common in the Chicago area to price a loan to show no points or origination fees, but with the customer paying the normal costs at closing. If someone wants a lower rate, I can price it so that they pay more money up-front (points) and get a lower interest rate. We can also do it the other way, offering them a slightly higher interest rate means that the lender pays us a higher premium, which can then be used to cover all of the loan costs. This program isn't available with all lenders, but is available with many mortgage brokers or mortgage bankers.
Here is how it works. Let's say you have a mortgage with a balance of $250,000 and an interest rate of 6.75%. This loan would have a monthly payment of $1,621 for principal and interest. Let's say that rates drop. If you are able to refinance at 5.75%, your new payment will be $1,459, for a savings of $162 per month with closing costs of $2,000.
If 5.75% is available with closing costs, the rate with no closing costs would be around 5.875% - just an eighth of a percentage point higher. This means a payment of $1,479 and a savings of $142 per month. The monthly savings are lower, but you save $2,000 up front. This works especially well for people who don't plan on being in their home or their mortgage forever, or if you think that the rate trend is going down and there may be more opportunities to refinance and lower your payments again down the line.
No-cost refinances work best when the loan amount is higher. In many cases we can do a no-cost refinance for the same rate as other companies are doing full cost loans. Smaller loans, those under $150,000 are harder to do without any cost. The smaller the loan the higher the interest rate would need to be in order to cover all the closing costs. This won't be the best route for everyone, but, depending on your situation, it could be a great option.
Things to watch out for - A true no/cost refinance means that you are not paying any fees or costs to get the loan. This is different than adding the fees and costs back into the loan. This means that your mortgage will be larger, and you will be paying the costs of refinance over the years you have the loan. There is no money coming out of your pocket at closing but you are still investing extra money. If you sold the home or decided to refinance again later, the money you paid will be gone. In some situations this could be the right way to go, but it is not a no-cost refinance. You need to know exactly what it is you are signing up for. That way, the next time you go a party you can be the one doing the bragging .
Pete Thompson is an Illinois mortgage banker who provides superior mortgage service and competitive mortgage rates in Chicago, the Chicago area and throughout Illinois. Click here for a Free copy of The Real World Home Buyer's Guide - How to Save Thousands when Buying a Home and Getting a mortgage. For information on the latest mortgage news and current Illinois mortgage rates, please visit http://www.illinoismortgageratesandnews.com/