In recent years, Americans seeking to take advantage of low interest rates have lined up to refinance their mortgages. In fact, refinancings hit an all-time high in 2003, and remained high in both 2004 and 2005, according to the Mortgage Bankers Association of America. With mortgage interest rates continuing to be among the lowest in homeowners' lifetimes, more Americans are refinancing their mortgages. In fact, through July of this year, Freddie Mac and Fannie Mae had refinanced 2.9 million home loans. The vast majority of refinanced loans were fixed-rate mortgages, whether the original loan was an adjustable-rate mortgage (ARM) or a fixed-rate mortgage. The good news for borrowers is that 30-year fixed-rate mortgages have been available at interest rates just one-tenth of a percentage point higher than ARMs, offering much greater stability with a long-term rate. Some borrowers have been able to save even more by refinancing from a 30-year mortgage into a 15-year term, meaning they will be able to pay the loan off much sooner -- with much less interest paid -- and still obtain affordable monthly payments.
The old and arbitrary rule of thumb said that a refi only makes sense if you can lower your interest rate by at least two percentage points for example, from 9% to 7%. But what really matters is how long it will take you to break even and whether you plan to stay in your home that long. In other words, make sure you understand -- and are comfortable with -- the amount of time it will take for your overall savings to compensate for the cost of the refinancing.
If you are considering refinancing in the coming months, consider this: If you had a $200,000 30-year mortgage with an 8% interest rate, your monthly payment would be $1,468. If you refinanced at 6%, your new monthly payment would be $1,199, a savings of $269 per month. Assuming that your new closing costs amounted to $2,000, it would take eight months to break even. ($269 x 8 = $2,152). If you planned to stay in your home for at least eight more months, then a refi would be appropriate under these conditions. If you planned to sell the house before then, you might not want to bother refinancing.
Here are some things you need to think about:
1. DO spruce up your credit score: Check your score before applying for a refinance. Interest rates vary depending on the borrower's credit history, with the best rates going to those with credit scores of at least 740. If you can wait a few months to refinance, strengthen your score by paying all bills on time and paying off as much debt as possible.
2. DO think about a shorter-term mortgage: If you can afford to pay a little more every month on your mortgage, you might want to refinance into a 15-year, rather than 30-year, loan. The monthly payment will be higher, but you will pay a lower interest rate (currently, about one-half percent lower) and less overall interest. Additionally, if you have already paid your mortgage for several years, choosing a shorter term will let you avoid "resetting" the length of time until payoff.
3. DON'T stretch beyond your means. Standard guidelines call for keeping housing expenses below 35 percent of total income, and you are wise to stay within that limit. Be certain that a new mortgage payment will be affordable.
4. DO consider paying points: Points (or discount points) are a percentage of the purchase price paid upfront to obtain a lower annual percentage rate on the loan. If you plan to stay in the home a long time, paying points might make sense. If you do pay points, bear in mind that they are usually tax-deductible on your federal income tax return.
5. DON'T forget private mortgage insurance (PMI). Mortgages with less than 20 percent equity require PMI in case the owner defaults on the loan. If a refinance puts you below 20 percent equity, the lender will add PMI requirements -- either as a monthly payment, as an up-front payment, or both. When the home owner pays a conventional mortgage down to 80 percent or less of the home's value, he or she can request the lender to cancel the PMI and then be able to stop paying the additional amount. Meanwhile, PMI is tax-deductible, at least through 2010.
6. DON'T count on a high appraised value: These days, lenders are very cautious about overvaluing homes. Appraisers are acting very conservatively, relying on comparative property sales figures from very recent sales. To get the best refinance deal, you should have equity totaling at least 20 percent of the appraised value.
7. DON'T rule out government programs. If your home value has seriously dropped or you have an ARM on which payments have skyrocketed, federal government home loan programs might be able to help. The Making Home Affordable Refinance Program (HARP) allows borrowers with mortgage debt of 80 percent to 105 percent of the home value to refinance without paying additional PMI.
With mortgage rates still in the low 5-percent range, it is a great time to refinance a home. By following these suggestions, homebuyers can be well prepared to make their biggest investment -- their home -- an even better value.
