Honey, I Shrunk the Mortgage!

Last Updated Aug 5, 2010 11:03 AM EDT

Last Week I wrote about mortgage financing advice for home buyers.

But folks who already have a mortgage should also consider their refinancing options now, while mortgage rates are at record lows.

Some of the same rules still apply, which are below. But mortgage bankers are seeing a new trend in what's called a cash-in refinance.

Honey, I Shrunk the Mortgage!
When home values were rising, many homeowners tapped their homes equity by replacing a smaller mortgage with a larger one, taking the difference in cash. But now, more homeowners are doing the reverse, bringing cash to the closing table and replacing their larger mortgage with a smaller one. In fact, 22 percent of homeowners who refinanced in the second quarter opted for a cash-in refinance, the third highest level since Freddie Mac started tracking mortgage refinancing activity in 1985.

Cash in refinancing is gaining more attention as folks see record low mortgage rates as an opportunity to refinance and save money. In the process, more people are paying down their mortgage as they see doing so as the best use of extra cash. Banks and money market funds pay less than one percent and the stock market can expose them to big losses.

There are several other very compelling reasons why it's worth it to shrink your mortgage when you refinance it. Here are a few:

  • Mortgages that are less than 80 percent of the homes appraised value escape the additional cost of private mortgage insurance.
  • Folks with mortgages that are a lower percentage of the home's value (60 percent or less) and have higher credit scores (740 or more) can qualify for the lowest interest rates on refinanced loans.
  • Banks charge a lower interest rate on mortgages below the conforming loan limit of $417,000 (and $729,750 in certain areas designated as "high cost") versus rates on mortgages over these limits; the so-called jumbo mortgages.
Replace a Used 30 with a New 20
Folks considering a cash-in refinance should also consider replacing their 30-year mortgage with a mortgage with a 20 year term. For some it would be a mistake to refinance back to a typical 30 fixed mortgage when you are well into the first ten years of the term. The reason is because most of the payments in the beginning of a mortgage are interest and borrowers pay the most interest during in the first 10 years of this type of loan. By refinancing back into a 30-year loan you go through this high-interest period again. Instead, refinance into a 15 or 20-year fixed rate mortgage. If you had a 30 fixed mortgage for 7 years try refinancing to a 20 year mortgage. The lower interest rate will also help to make the payments on the 20 year loan more affordable.

30 year mortgage: Total interest paid over...

  • First ten years = $86,640
  • Next ten years = $63,256
20 year mortgage: Total interest paid over...
  • First ten years = $73,923
  • Next ten years = $29,747
Example assumes $200,000 loan at 4.75% and 4.5%.

Refinancing Guidelines
New Interest Rate is One Percent Less: Homeowners who can reduce their mortgage interest rate by at least one percent should start looking into their refinancing options. Folks with adjustable rate mortgages should not miss this opportunity to lock in the certainty of a low fixed rate, even if their current rate is lower than the fixed rate.

Savings Recovers Closing Costs in 24 Months or Less: If the savings created by your new lower mortgage payment recoups the closing costs in 24 months or less, and you plan to keep the home for at least that long, then refinancing can be worth it. If you refinanced in the last year or two, just be sure to consider any closing costs from your last refinance that have not yet been recovered.

Homeowners with larger mortgages should definitely look at refinancing again, even if they refinanced in the last year or two. The monthly savings from lower interest rates for larger mortgages are greater and can recover the costs of a refinancing more quickly.

Today's mortgage refinancing reality for folks who are unable to prove their income and assets with documentation is a struggle to find any reasonable refinancing options. Expect most lenders to require full documentation of income and assets with your mortgage application. This includes pay statements from the past three pay periods, three months bank statements and tax returns for the past two years. Requirements may also include having cash in reserve equal to six to 12 months of mortgage, insurance and tax payments. In most cases 70 percent of retirement account balances count towards this requirement.

If you can provide documentation of the income and assets required, your credit score is 700 or higher, have no late payments, your mortgage loan amount is less than 80 percent of the homes appraised value, and the loan amount is not more than $417,000 (up to $729,750 in designated high-cost markets) then you'll have many refinancing options available.

With mortgage rates touching historic lows, don't wait to catch the bottom in mortgage rates. How can you beat this? If while you are waiting your financial condition unexpectedly takes a turn for the worse (you lose your job, etc) then you may not qualify to refinance and could miss out on what could be the lowest mortgage interest rates you will ever see.

If your mortgage is almost as much as your home's value, or is underwater (where the home is worth less than the amount of the mortgage), refinancing may still be available through the government sponsored Home Affordable Refinance Program, or HARP. This program allows mortgages financed by Freddie Mac or Fannie Mae, with loans up to 125% of the home's value to be eligible for this special refinancing program.

Unless there is a new government-sponsored program, many homeowners will not be able to refinance and take advantage of these record low interest rates. For folks who are working but making a lot less than they were, or who are unemployed, refinancing is generally not an available option.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.