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Refinance your mortgage

Refinancing your mortgage can give you access to your home's equity and a cheaper interest rate. If you stay put long enough, the extra fees may be worth it.

Refinancing means paying off your old loan(s) with a new mortgage loan. If mortgage rates are now lower than what they were when you obtained your first mortgage, then it will probably make sense to refinance. As an example, an owner who refinances a $200,000 fixed-rate, 30-year mortgage at 8% for a new loan at 6% will have new mortgage payments that are $268 a month lower. To get the loan, however, you will generally be paying fees for loan origination, home appraisal and credit check, points, etc.

One of the questions that is always asked concerns when one should consider refinancing their mortgage. Some likely situations include:

  • Current interest rates are 2% or more less than those on your current mortgage.
  • Rates are at least 1% lower, but you plan to stay in the house for many years to come.
  • You figure you could pay off a new loan in less time with roughly the same payment you are making on your current mortgage.

The downside to refinancing, other than the new closing costs which can be included in the new mortgage, is that you are basically starting over with a new loan. For example, let's say you have been paying on your current 30-year mortgage for five years. During this time, you have basically paid off very little principal, and with the fees your new mortgage amount will be about the same as your old mortgage. Although the new monthly payments will be lower, you will now have five more years to pay on your new mortgage since it will be a new 30-year mortgage.

Another reason some people refinance is to borrow money for a major purchase, remodel the house, or debt consolidation. This could also be accomplished with a home equity loan, but if the interest rates are now lower than what they were, this may be the best way to get the cash you need. This "cash out" or "cash back" mortgage works when your home has gone up in value, meaning it has the necessary equity for you to borrow, and a refinance makes better sense than a home equity loan. For example, let's say that your current 30-year fixed-rate mortgage is $200,000 and your monthly payment at 9% is $1,609. Let's also assume that your house can appreciated and is now worth $300,000. You could get a home equity loan and borrow up to $40,000, but your first mortgage would still be at 9%, way too high. It would make better sense to refinance at the present rate of 6%. Not only could you get the $40,000 cash you want, but your new monthly mortgage payment would in fact be lower by about $200 a month.

Refinancing can make sense even if you don't need to tap the equity in your home. Consider refinancing anytime there's a difference of two percentage points or more between your fixed-loan rate and current rates. The two-point rule works in your favor when you stay in the house long enough for lower monthly payments to offset the costs of refinancing -- usually several years. Refinancing with less than a two-point differential can be advantageous if you plan to live in your home for a longer time. Even a 1.5-point spread can do the trick when you stick around more than seven years. Use Kiplinger's am I better off refinancing? calculator to figure out if this is a good choice for you.

What about adjustable rate mortgages (ARMs)?
If the current rate is less than your ARM rate, then definitely refinance if for no reason that to lock in the new lower rate. However, if your current ARM rate is below today's 30-year fixed rate, you will need to consider your best option: should you keep your ARM, convert to a fixed rate mortgage or take advantage of low teaser rates on new ARMs?

Switching to a fixed rate. If you plan to stay in your house, it could make sense to lock in a fixed rate. You wouldn't necessarily save a lot of money compared with the ARM you trade in, but you'd have peace of mind knowing your rates won't rise.

An ARM for an ARM. When first year "teaser" rates are two to three percentage points lower than your current ARM, it's tempting to consider switching an old ARM for a new one. First-year payments would drop substantially. But after that, the interest rate would reach about what it would have been on your old ARM, assuming the index and margin were the same. You come out ahead only if your first-year savings exceed the cost of refinancing.

Switching from a fixed-rate to an ARM. If you plan to sell within one to three years, you could cut your monthly payments dramatically by switching to a new lower ARM.

Tax concerns
When you're refinancing just the balance of your mortgage, interest on the entire amount is tax-deductible. If you borrow additional money, the interest on up to $100,000 extra is deductible as home-equity debt.

Unlike points for the original mortgage, points for refinancing must be deducted over the life of the loan, whether you pay in cash or add them to the loan, unless you use the funds for improvements to your home. If you use all additional funds from the refinancing for home improvements, you can deduct all interest payments on the loan and the full amount of the points related to the improvement.

You can keep money in your pocket by including the closing costs in the loan. This also allows you to add otherwise nondeductible charges, such as the appraisal fee, to the amount on which you pay deductible interest.

Refinance to a 15-year mortgage
Although most people refinance to a new 30-year mortgage to lower their monthly payments, it may be appropriate to consider a new 15-year mortgage. If the rates have dropped 2% or more since your original mortgage, you can afford the current monthly payment, and you have a sufficient emergency fund, it is definitely advisable to consider a 15-year payment period. It's amazing how little principal is paid off during the first five years of a 30-year mortgage as compared to a 15-year mortgage.

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