Refinancing Your Mortgage
Lower Your Payment, Lower Your Rate or Get Cash Out
Refinancing your home is an extremely popular thing to do as rates continue to spiral downward. You can dramatically lower your payments with a rate reduction or you can easily get cash out based on the equity in your home to consolidate debt. Now is an excellent time to explore your options! Make sure your refinance makes sense for your situation. We can help you understand your options and how they can affect your bottom line.
Traditionally, the decision on whether or not to refinance has meant balancing the savings of a lower monthly payment against the costs of refinancing. But in recent years, companies have introduced “no cost” and low cost refinancing packages that minimize or completely eliminate the out-of-pocket expenses of refinancing. (These refinancing packages compensate with a higher interest rate, or by including some of the costs in the amount that is financed.)
With traditional refinancing, the most often cited rule of thumb is that the interest rate for your new mortgage must be about 2 percentage points below the rate of your current mortgage for refinancing to make sense. However, with the newer low and no cost refinancing programs, it can be worth your while to refinance to obtain a smaller reduction in interest rates.
How long you expect to stay in your home is also a factor to consider. If you’ll be moving in a few years, the month to month savings may never add up to the costs that are involved in a refinancing.
Mortgage Refinance Costs
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 obtaining a loan. To obtain the lowest rate offered, most mortgage companies 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 company might charge you between $3,000 and $6,000. However, some companies may offer zero points at a higher interest rate, which may significantly reduce your initial costs, although your payments may be somewhat higher.
Trade Your ARM for a Fixed Rate
By switching to a fixed rate loan, you will not only reduce your payment, you will also likely lock in an attractive rate for as long as you own your home.
In fact, while one year ARMs currently offer tempting introductory rates, most experts recommend avoiding them, because you could easily find yourself facing sharply higher payments in the near future, even if interest rates don’t rise. Why? Well, after the introductory rate expires, ARMs are typically pegged to the one year Treasury rate (recently 5.25%) plus 2.75 percentage points, with increases of as much as two points a year. Assuming interest rates don’t change, you would pay 7.59% in the second year (the full two point increase) and 8% in the third year.
There are certain cases, however, where an ARM makes sense. If you are fairly certain you’ll be moving within five years, you can save some money — and avoid rising payments — with a five year ARM. Such loans offer a fixed rate for five years and adjust annually thereafter.
Analyze Your Savings
Check the market closely to determine the available rates and costs associated with refinancing. These costs can include items such as an appraisal and other various 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 companies 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.
Your Personal Income Taxes
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 loan or a portion of the loan is for home improvements, you may be able to deduct the points or a portion of the points. Check with the IRS regarding the current rulings on refinancing, particularly if you are using the new loan to make home improvements.
Refinance Once Then Do It Again
When rates fall steadily, refinancing may make sense even if you have done so once already. Bob and Michelle Barbo of Kirkland, WA refinanced twice within three months in 1998. In October, they trimmed the rate on their 30-year fixed mortgage by a full point — from 9.13% to 8.13% — for a monthly savings of $63. Plus, because home prices in their area had boosted their home equity, they were able to stop paying private mortgage insurance that cost them $120 a month.
To exploit continued decline in rates, the Barbos refinanced again in December. Their new 30-year fixed mortgage is at 7.375%, lopping another $55 off their monthly bill. Since the couple had chosen a no cost refinancing each time, their total out of pocket expenses came to just $400 in appraisal fees. So by the time you read this, they will already have recouped their up front costs. “Now we can use the savings to build up a cash emergency fund,” says Bob.
If you are considering a second refinancing, don’t overlook this potential tax write off: When you pay points to refinance, you must deduct the amount over the life of the loan, usually 30 years. But when you refinance a second time, all of the points that have not yet been deducted from the first refinancing can be written off in a lump sum. Say you refinanced to a 30-year mortgage in 1993 and paid $3,000 in points. By now, you would have written off roughly $500. If you refinance again this year, you could deduct the remaining $2,500 on your 1998 tax return. For a homeowner in the 28% tax bracket, that works out to a savings of $700 — enough to offset some or all of your costs this time around.
However, many companies 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.
