Introduction

The rule of thumb widely published years ago was to refinance only if you could lower your mortgage interest rate by at least two percentage points. This general rule was a simple way to analyze the refinance, allowing consumers to consider the rough costs of refinancing. That rule no longer holds true in today's market, because you can refinance your mortgage for no closing costs, or no points.

When a refinance costs you nothing, any savings in the rate is pure gravy. "No-closing-cost" refinances are just one of the "two-percent rule" breakers. We'll discuss these and other reasons to consider refinancing in this article.

Here are some of the most popular reasons to refinance:

• Lower your monthly mortgage payment to improve cash flow
• Switch from an adjustable-rate mortgage (ARM) to a fixed rate loan
• Switch from a fixed rate loan to an ARM
• Free up tax-deductible cash
• Eliminate Mortgage Insurance (MI)

"No-Closing Cost" Loans top

Any loan where the lender pays all of your closing costs (like title and escrow fees, appraisal, lender's fees, etc.) is commonly referred to as a "no-cost" loan. A true "no-closing-cost" loan differs from both a "no lender fee" loan or a loan in which the lender adds the closing costs to the amount financed. A "no lender fee" loan, sometimes advertised by banks, usually will not cover the title, escrow, and other outside charges you may need to complete the refinance.

With a true "no-closing-cost" loan, you can refinance for any incremental drop in your interest rate since the transaction costs are zero. Even in a declining rate market, where you believe rates may continue to fall, a no-cost loan will make sense. Should rates continue to decrease you will have invested nothing in the loan costs and can simply refinance at any time. Some borrowers refinance every year or less!
No-cost loans will always carry a slightly higher rate than a loan that does not pay your costs. In general, a no-cost loan is the better strategy if you plan to keep your loan for the next two and a half to three years. Longer than that, you should consider paying the costs yourself to get a lower rate. Over time, the lower rate will save you more money. And if you plan to keep the loan for four to five years, it often makes sense to pay points to get an even lower rate.

Lower Your Monthly Mortgage Payment top

One of the most common reasons for refinancing is to lower the monthly payment. The analysis here is simple. Ask your mortgage source what the costs involved are (all costs, not just the lender's fees). Verify this by asking what loan amount the new payment is based on. Then take the cost of the refinance and divide by your monthly savings to determine the "break-even" point in time. So long as you plan to keep that loan for some time longer than the break-even point, it's advantageous to refinance.

Even with a loan that includes costs, at times it may make sense to lower your payment by wrapping the costs into the new loan balance. Just be aware that the costs are increasing your principal balance owed and still do the analysis above. By following this strategy of increasing your mortgage balance, you are borrowing against your home's equity.

Of course, with a no-cost refinance, the break-even is immediate because you are reducing your payments without investing in the closing fees or increasing your outstanding loan balance.

Sample Analysis top

Let's assume that your original loan was for $200,000 and your interest rate is 8.0%, with payments of $1,469.21. Perhaps you've had the loan for three years and the balance is paid down to approximately $194,500. After talking to a mortgage source, you are quoted 7.75% with payments of $1,409.51. "Why, that's a savings of almost $60 per month," they tell you. But what about the closing costs? Remember to ask if there are any costs, and if so, how are they paid? By the lender, or will they be included in the amount financed? We'll show you how to make the right decision.

In this example, the lender is proposing to include the $2,000 in closing costs into the new loan balance of $196,500. At 7.75% the new loan will give you a lower payment, but it is still worthwhile to consider the costs that are being financed. Although the payment is lower than your current loan, you must also keep in mind that the loan period is being extended by stretching the larger loan balance out over a new 30-year term.

In this example, with a savings of approximately $60 per month, recouping the closing costs will take 34 months, which is explained in the table below. In this current interest rate market, you should be able to keep your break-even point at 24 months or less. Try a different mortgage, look for lower costs, or monitor the market until rates improve slightly.

Other loan programs may be available to help lower your payment without relying on the strategy of wrapping your closing costs into the loan balance. You may want to consider a shorter fixed term, such as a five- or seven-year fixed, that converts to an ARM, an annually changing adjustable-rate mortgage, or a loan with a monthly payment option plan (and then pay only the minimum payment possible).

Switch from an Adjustable-Rate Mortgage (ARM) to a Fixed-Rate Loan top

Has your ARM moved up on you in the last few years? Don't feel like starting with another low rate and watchingit move up all over again? Consider refinancing into the security of a fixed-rate loan but remember that all fixed-rate loans are not the same.

Today's market offers numerous choices for loans that are fixed for a shorter time than the traditional 30 or 15 years. Loans are available with fixed rates for 3, 5, 7, and 10 years, and the shorter the initial fixed period, the lower the interest rate. All of these loans are amortized over 30 years, so there's no need to worry about the payment being too high. All you need to do is match up how long you expect to keep the loan with the closest fixed term. This may be shorter than how long you plan to keep your home, if you feel comfortable with the refinance process.

At the end of the fixed term, these loans automatically convert into ARMs with adjustments annually, so there is no balloon payment. Tip: As the market shifts around daily and weekly, you might be able to get a seven-year near the cost of a five-year, so keep your eyes on both.

Often the current fixed rates will be somewhat above the rate on your current ARM, unless you are several years into your adjustable. You will need to decide if the security and insurance against further rate increases is worth the additional payment that you might incur.

Switch from a Fixed-Rate Loan to an Adjustable-Rate Mortgage top

OK, you're probably wondering what's going on. One minute we suggest getting out of an adjustable, and then turn around and suggest you go into an adjustable. But it really can make sense in some situations.

If you've recently decided to start looking for a new home, or will be relocating within the next few years, it may make sense to evaluate your current loan. By switching from a 30-year fixed to a low-rate adjustable or short-term fixed, such as a three-year fixed, you can save substantially over the remaining time that you'll be in your home. In this type of situation, it almost never makes sense to pay closing costs, so shop for a no-cost loan with a slightly higher rate. Also, don't take a loan with a prepayment penalty, unless the prepayment is waived upon sale of the home. This strategy can be best explained by showing an example. For simplicity, we're assuming that your loan balance is the same on both the refinance and the original loan.

Take Cash Out of Your Home top

The primary advantage of home mortgage loans is that the interest costs are deductible for tax purposes. If you are currently paying a higher rate of interest on credit cards, car loans, or other forms of debt that are not deductible, it may make sense to pull the cash out of your home (provided that you have the equity) and use it to pay off those other debts.

Lenders will typically allow you to borrow up to 75 percent of the appraised value of your home in a cash-out refinance. (Some lenders will go up to 80 percent; however, the loans offered will be less competitive than at 75 percent.) Paying off other bills or credit cards, buying a new car, sending the kids to college, investing in an Internet start-up, or buying additional real estate are all good reasons to refinance your home and take cash out.

Even if you're able to keep you credit card interest rate at 8 to 9 percent with low introductory offers, when you consider the tax savings of your mortgage interest, you will be paying less interest if those balances were part of your mortgage instead. If you are paying 8 percent on your mortgage and your tax bracket is 33 percent, your net interest rate is 5.3 percent which is still less expensive than any credit card program over time.

Eliminate Mortgage Insurance (MI) top

If you purchased your home with less than 20 percent down, chances are you have a loan that is insured by "Mortgage Insurance" (MI). Most borrowers are aware that they are paying MI on a monthly basis, but you can check your mortgage statement if you're not sure. As your home appreciates or your loan balance decreases (or a combination of the two), your equity in the home will exceed 20 percent. At that time a favored method of eliminating the MI tied to the loan is to refinance. The savings of eliminating the MI alone will often warrant refinancing.

Be aware that mortgage lenders value your property at what comparable homes have sold for in the past six months, not what they are currently listed for. If you are close to that 20 percent mark, ask your mortgage source to provide you with a "comp search" estimate (this service should be available for free) which will give you an idea of how your lender will view your home's value.

If you are currently in a low-rate fixed mortgage, don't refinance simply to remove MI. Instead, work with the existing mortgage holder so that you can keep that low rate and still reduce your payment by removing the MI premium. Because the lender does not have as strong an incentive as you to eliminate the MI portion of your payment, there sometimes appears to be an unwillingness to assist in this process of removing the MI. Do not be discouraged by the lack of information or cooperation if you do encounter some resistance. Request in writing the lender's policy on eliminating MI and work with the lender until they have satisfied you.

But I Don't Want to Extend My Loan Term! top

On a final note, some people hold on to their loans simply because they do not want to extend the remaining time that they'll be paying on a mortgage. If you are five years into a 30-year fixed loan, with 25 years remaining, how can you be certain that you're making the right choice by refinancing into a lower rate? Doesn't the fact that you're potentially extending your loan term wipe out the potential savings of the lower rate? Absolutely not!

The simplest way to prove this is to take the new loan and amortize it over the remaining term of your current loan. That is, assume that you still want to pay off your loan in 25 years, and then calculate what your payments need to be to make this happen. Now compare your total payments with the new lower-rate mortgage versus your existing loan. If your total payments over the remaining term are lower, this means that you're paying less interest and it makes sense to refinance. Because all lenders will accept an additional payment toward principal on a monthly basis, you can be certain that your loan will get paid off on time and you'll save on interest costs. Let's let the numbers speak for themselves: