Interest rates have fallen approximately half a point in the last few weeks. Some mortgage experts are making noises about how homeowners should run out and refinance their loans.
That might be the right advice for some, though it won’t work for everyone. While there’s nothing wrong with investigating rates, there are a few basic rules that every savvy homeowner should follow before deciding whether or not to refinance:
1). Look up the interest rate on your current loan. When you’re in the process of getting a loan, all you can think about is the interest rate. You live, breathe, eat, and sleep interest rates until you actually lock in on yours.
But once you’ve signed your loan papers and closed on your new home, the focus quickly shifts away from the interest rate to the total amount you’re paying each month for your mortgage. After a year or two or five of writing mortgage checks, it’s easy to forget whether you’re paying 8 percent or 8.5 percent on your 30-year fixed.
Before you do anything else, be sure you know exactly what your rate is and what your loan terms are. Then, you can begin to make an objective comparison with other rates and loan products being offered in the market.
2). Shop Around For The Best Rates. Although newspapers, and perhaps even the Internet, are good places to start, they are by no means the only way you should shop for interest rates. Newspaper ads rarely give the kind of detail about closing costs and fees that can quickly jack up the real interest rate you’re paying.
Once you’ve identified a few lenders who appear to be offering low interest rates, call them and ask about all the closing costs and fees that you’d be required to pay if you took out a loan. Press the loan officer to disclose all fees, including document preparation fees, loan origination fees and discount points. Make a list of all of the fees each lender charges so you can compare them, apples to apples. If you don’t understand exactly why a fee is being charged, ask.
One of the easiest types of loans to compare is the “no point, no fee” loans offered by many lenders. While your interest rate will be higher with this type of loan, your job as the homeowner is to find out which costs are being folded back into the rate. Be sure to look at the annual percentage rate (APR) which folds all of your costs into one bottom line interest rate number.
3). Do The Math. Just because the current interest rate is lower than the interest rate you’re paying isn’t necessarily enough reason to justify refinancing. You need to look at how much lower the interest rate is, what other kinds of fees are involved, and how long it will take you to start saving money with the new loan.
For example, if you’re refinancing your $100,000 loan to lower the interest rate you’re paying from 8.5 percent to 8 percent, you’ll save $35.15 per month. If you have $500 in refinancing costs, it will take you approximately a year and a half to pay yourself back and start saving money.
Still, money saved is money saved. The rule of thumb used to be that if you could shave two percentage points or more off your loan, it was worth refinancing. Today’s thinking is this: if you can save money from the get-go, you should refinance.
4). Watch Out for Pre-payment Penalties. Although they’re illegal in many states, some lenders with federal charters have begun inserting pre-payment penalty clauses into loan documents. Essentially, a pre-payment penalty means you’ll be charged a penalty or fee if you refinance before the pre-payment penalty expires, usually within 5 years of closing on your loan. For example, if your pre-payment penalty is 2 percent of the loan amount, and the balance of the loan is $100,000, you’ll owe a $2,000 penalty in addition to paying off your loan amount.
If your loan contains a pre-payment penalty, you’ll have to see if you’ll save enough money by lowering your interest rate to cover the cost of the penalty. If it doesn’t, you might have to forego refinancing until the penalty period expires.
5). Factoring in Tax Deductions. Even if you’re going to save money from the first day, it’s important to think about how much you’ve paid down your current loan, and what kinds of benefits you might be achieving from paying down your current loan, rather than tacking on extra years of interest payments.
Here’s how a 30-year loan is amortized: You spend the first 10 years payment mostly interest, the middle 10 years paying about half interest and half principal, and the final 10 years paying mostly principal.
If you’re in year 12 of a 30-year loan, you’ve already paid the majority of the interest due on your loan. Now is when you’ll really begin building up equity quickly. If you refinance and take out another 30-year mortgage, you may be tacking on an extra 12 years’ worth of interest payments, essentially paying interest twice on the same money. While you can deduct the interest paid on your mortgage off your federal income taxes, it’s still cash out of pocket.
If you want to save on the interest rate, a better option may be to cut the length of your mortgage from 30 years to 15. That way you can take advantage of lower rates while building up equity quickly. Also, don’t take cash out when you refinance. If you owe $75,000 on your original $100,000 loan, simply refinance the remaining loan balance. Consult with your tax advisor or accountant for more details.
6). Think About How Long You Plan To Stay. Even if you’ll save a few dollars, refinancing can take an extraordinary amount of time. You have to shop for the loan, fill out the application, work with the lender, provide all sorts of documentation, and close on the loan.
Let’s say you’re only planning to stay in your home for a couple of more years, and it will take you 1.5 years to pay off your refinancing costs and fees. Even if you’ll save $200 between the time you pay off the refinancing expenses and the time you sell your home, that cash may not offset all the time you’ll spend agonizing over rates, choosing a lender, and making sure the refinancing is done correctly.
Aug. 12, 1996.
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