Why refinance?
If interest rates dive, your current loan could suddenly
become more expensive than a new loan with a lower rate. You may just want to
lower your monthly payment or tap some of the equity you've built up. Or you
may want to change loans altogether, switching from a 30-year to a 15-year loan
term or from an adjustable to a fixed interest rate. Even if you don't think
you're ready to refinance now, it doesn't hurt to check your numbers and look
at current loan rates. The lower your new interest rate, the less it will cost
you to refinance, and the longer you plan to hold your new loan, the more likely
it is that you'll save significantly in the long run. Time Is Money To recoup
the cost of refinancing and achieve real savings, you need a realistic estimate
of how long you'll stay in your house. Consider all possibilities, such as whether
your job could change or if you could be transferred. Then do the math. On a
30-year, $120,000 loan at 7 percent, you could save about $20 a month for every
quarter-point reduction in interest. If your new rate is 1.5 percent less than
what you currently pay, that could mean saving as much as $120 a month, or $43,200
over the life of your loan. You may only plan to stay in your house five years,
though, which means you would save only $7,200. If it costs you $3,000 to refinance
your loan, your total savings then drops to $4,200. If you stay in the house
only three years, you save even less. Assess your time frame realistically. It
will help you know whether refinancing is for you, and also help you choose the
right loan. Choosing a New Loan
When you refinance, you essentially reset the clock on paying
for your house. Refinancing can be an effective savings tool
if you want to trim your monthly payment or cut the overall
interest you pay on your loan, especially if you match your
new loan to the amount of time you plan to keep your house.
For example, if you keep your house a long time, refinancing
from an adjustable-rate loan to a fixed-rate loan could save
you significantly over the long run. If your current monthly
payment is comfortable and you plan to keep the house a while,
refinancing from a 30-year loan to a 15-year loan could cut your overall interest
payments and build your equity faster. The tradeoff is this: while the rate
will be around 0.25 percent lower on a 15-year loan, the
payment (figured on a shorter term) will be about one-third
larger. On the other hand, if you stay in your house only
three to five years, you may want to look at adjustable-rate
or balloon-payment loans so you can take advantage of the
even lower rates these loans carry in the early part of their
terms.
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Comparing Refinancing Deals
Compare both short-term (or up-front) and long-term costs
for loans of equal amounts to make a fair comparison. Short-term
costs include points and closing costs you'll pay. (Your
lender is required to provide a written estimate of settlement
costs with a refinanced loan, just as with a home purchase
loan.) The long-term cost is the total interest on the loan.
To compare total interest, get an amortization chart from
your lender or ask your loan agent to help you. An amortization
chart breaks down each monthly payment into interest and
principal amounts for any interest rate. For example, if
you plan to hold your loan for five years, total the interest
for the first 60 payments on various loans you're considering.
Then add the short-term costs for each option. Compare the
results with your current loan. Alternatively, have your
lender give you a modified Annual Percentage Rate (APR)--which
wraps both of these costs into one figure--for each loan
you are considering. This tells you which loan option will
cost you the least, apart from differences in timing of interest
costs versus up-front costs, which could be significant.
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To Refinance or Not to Refinance
One way to compare is to weigh interest rates, closing costs
and total interest accrued against the length of time you
think you'll hold the loan. In the example below, a new 30-year,
fixed-rate loan (at 6.875 percent interest with two points)
offers greater savings than the existing loan or a new loan with no points.
However, the savings in total payments or total interest alone come to little
more than $1,100 on both refinanced loans if you hold the new loan only five
years How much will it cost to refinance your mortgage? When you refinance your
mortgage, you usually pay off your original mortgage and sign a new loan. With
a new loan, you again pay most of the same costs you paid to get your original
mortgage. These can include settlement costs, discount points, and other fees.
You also may be charged a penalty for paying off your original loan early, although
some states prohibit this. The total expense for refinancing a mortgage depends
on the interest rate, number of points, and other costs required to obtain a
loan. To obtain the lowest rate offered by the lender, most lenders will charge
several points, and the total cost can run between three and six percent of
the total amount you borrow. So, for example, on a $100,000 mortgage, the lender
might charge you between $3,000 and $6,000. However, some lenders may offer
zero points at a higher interest rate, which may significantly reduce your initial
costs, although your payments may be somewhat higher.
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Is the interest rate low enough to save
you money?
Talk to
some lenders to determine the available rates and the costs
associated with refinancing. These costs include appraisals,
attorney's fees, and points. Then determine what your new
payment would be if you refinanced. You can estimate how
long it will take to recover the costs of refinancing by
dividing your closing costs by the difference between your
new and old payments (your monthly savings). However, the
ultimate amount you may save depends on many factors, including
your total refinancing costs, whether you sell your home
in the near future, and the effects of refinancing on your
taxes. The old rule of thumb used to be that you shouldn't
refinance unless the new interest rate is at least two percentage
points lower. However, many lenders are now offering zero
point loans and low-cost refinancing. Therefore, even if
your rate change is less than one percentage point, you may
be able to save some money by refinancing.
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How many "points" must
you pay to the lender to obtain the loan?
In refinancing,
lenders usually offer a range of interest rates at different
amounts of points. A point equals one percent of the loan
amount. For example, three points on a $100,000 mortgage loan would add $3,000
to the refinancing charges. Shopping for points as well as interest rates may
save you money. As a rule of thumb, each point adds about one-eighth to one-quarter
of one percent to the interest rate the lender is offering. Generally, the lower
the interest rate on the loan, the more points the lending institution will
charge. Some lenders offer refinancing with no points, but
generally charge higher interest rates. To decide what combination
of rate and points is best for you, balance the amount you
can pay up front with the amount you can pay monthly. The
less time that you keep the loan, the more expensive points
become. If you plan to stay in your house for a long time,
then it may be worthwhile to pay additional points to obtain
a lower interest rate. Some lenders may offer to finance
the points so that you do not have to pay them up front.
This means that the points will be added to your loan balance,
and you will pay a finance charge on them. Although this
may enable you to get the financing, it also will increase
the amount of your monthly payments.
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What other settlement
costs will the lender require you to pay at closing?
Settlement
costs typically include fees for the loan application, title
search, appraisal, loan origination, credit check, and lawyer's
services. You also may be required to pay recordation fees
or transfer taxes. If you are shopping for a lender, ask
each one for a list of charges and costs you must pay at
closing. Some lenders may require that some of these costs
be paid at the time of application.
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How would refinancing
affect the taxes you owe? With a lower interest rate on your home loan,
you will have less interest to deduct on your income tax return. That, of course,
may increase your tax payments and decrease the total savings you might obtain
from a new, lower-interest mortgage. You should be aware
of an Internal Revenue Service (IRS) ruling with respect
to points paid solely for refinancing your home mortgage.
IRS regulations require that interest (points) paid up front
for refinancing must be deducted over the life of the loan
-- not in the year you refinance -- unless the loan is for
home improvements. This means that if you paid a certain
number of points, you would have to spread the tax deduction
for those points over the life of the loan. If, however,
the refinancing is for home improvements -- or a portion
of the loan is for this purpose -- you may be able to deduct
the points -- or a portion of the points -- under certain
circumstances. Check with the IRS regarding the current rulings
on refinancing, particularly if you are using the new loan
to make home improvements.
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Should you also consider a different
type of mortgage?
If you are thinking about refinancing your
mortgage, you might want to consider other types of mortgages.
For example, you might want to look into a 15-year, fixed-rate
mortgage. In this plan, your mortgage payments are somewhat
higher than a longer-term loan, but you pay substantially
less interest over the life of the loan and build equity
more quickly. (Of course, this also means you have less interest
to deduct on your income tax return.) You also might want
to consider refinancing if you have an adjustable rate mortgage
with high or no limits on interest rate increases. You might
want to switch to a fixed-rate mortgage or to an adjustable
rate mortgage that limits changes in the rate at each adjustment
date as well as over the life of the loan. If you decide to apply for refinancing
with a particular lender, and if you do not want to let the interest rate "float" until
closing, get a written statement guaranteeing the interest rate and the number
of discount points that you will pay at closing. This binding commitment or "lock-in" ensures
that the lender will not raise these costs even if rates increase before you
settle on the new loan. You also may consider requesting an agreement where
the interest rate can decrease but not increase before closing.
If you cannot
get the lender to put this information in writing, you may wish to choose one
who will. Most lenders place a limit on the length of time (say, 60 days) they
will guarantee the interest rate. You must sign the loan during that time or
lose the benefit of that particular rate. Because many people are refinancing
their mortgages, there may be a delay in processing the papers. Therefore, you
may want to contact your loan officer periodically to check on the progress
of your loan approval and to see if additional information is needed.
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What do
you look for when shopping for a home mortgage?
If you decide to refinance your
mortgage, shopping around by calling several lending institutions to ask each
one what interest and fees they charge will help you get the best deal available.
Also ask each about their "annual percentage rate" (APR) and compare
them. The APR will tell you the total credit costs of the refinancing, including
interest, points, and other charges. Remember, you do not have to refinance
your mortgage with the same lender that provided your original mortgage. However,
to keep your business, some lenders will offer their original mortgage customers
the incentive of lower mortgage interest rates, sometimes with reduced closing
costs.
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What disclosure must the lender give you?
For a refinancing, the lender
must give you a written statement of the costs and terms of the financing before
you become legally obligated for the loan, as required by the Truth in Lending
Act. You usually will receive the information around the time of settlement,
although some lenders provide it earlier. You will want to review this statement
carefully before you sign the loan. The disclosure tells you the APR, finance
charge, amount financed, payment schedule, and other important credit terms.
If you refinance with a different lender, or if you borrow beyond your unpaid
balance with your current lender, you also must be given the right to rescind
the loan. In these loans, you have the right to rescind or cancel the transaction
within three business days following settlement, receipt of your Truth in Lending
disclosures, or receipt of your cancellation notice, whichever occurs last.
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Will the lender refund your application fees if you do not sign the mortgage?
When you apply for a mortgage, some lenders require you to
pay a special charge to cover the costs of processing your
application. The amount of this fee varies, but it may be
$100 to $200. Usually, you must pay this charge at the time
you file the application. Some lenders do not refund this
application fee if you are not approved for the loan or if
you decide not to take it. So, before you apply for a mortgage,
ask lenders whether they charge an application fee. If they
do, find out how much it is and under what circumstances
and to what extent it is refundable. However, if you elect
to cancel the transaction within three business days after
you close the loan, as discussed above, you are entitled
to a refund of all costs and charges imposed for the credit
transaction.
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