To Refinance Or Not To Refinance

Mortgage rates are at their lowest levels in more than a year. Low mortgage rates mean opportunities for home buyers and home owners. Personal Finance Adviser Ray Martin reports for The Saturday Early Show.

Interest rates have been trending back down for various reasons (the economy is strong, the bond market has been doing well and the Fed has cut rates recently). Lower interest rates mean that mortgage rates have come down. The typical 30-year fixed-rate mortgage (a popular barometer for all mortgage rates) is currently about 7 3/8 percent. These low rates present an opportunity for home buyers and home owners.

For home buyers, lower rates mean mortgage payments on new loans are lower, so owning a home is more affordable. For home owners, refinancing loans originally obtained over the last year (at higher rates) could mean substantial savings in the form of lower mortgage payments. Also, many homeowners with adjustable-rate mortgages may find that their mortgage rate has adjusted up from its original teaser rate and converting or refinancing to a lower fixed rate could be attractive. Of course, there are many questions to consider before getting a new mortgage or refinancing an existing one, so here are few guidelines:

Rates are low now. Is it better to get a fixed- or adjustable-rate mortgage?

This is the classic choice for most home buyers. The right decision has little to do with where rates are at a given point in time. It's more important to understand the differences between the two and make your choice depending on your needs.

The beautiful thing about fixed-rate mortgages is the peace of mind that home owners get from fixed mortgage payments that will never go up. This is comforting for most home buyers, considering that other home ownership costs usually rise (property taxes, maintenance and utilities). This is particularly important to first-time home buyers, who are ambushed with often unbudgeted expenses that come with first-time home ownership (home furnishings, lawn mowers, tools, etc.). They should go with the fixed-rate mortgage.

Lenders created adjustable-rate mortgages so that they could participate in increased interest income revenue during periods of rising interest rates. In short, adjustable rate mortgages were developed to protect the banks, not the home owner. Mortgage lenders generally offer incentives for taking an adjustable rate mortgage, such as "teaser rates," where the rate for the first year is very low (3 percent to 4 percent below fixed rates), which may allow the borrower to qualify for the loan. After the first year, the rate can go up to as much as 2 percentage points per year, so be prepared for this worst-case scenario.

Adjustable-rate mortgages primarily make the most sense for people who plan on moving in a few years. As a rule, do not take out an adjustable-rate mortgage because it's the only way you'll qualify for the amount you borrow.

Anther caveat: If you have an adjustable-rate mortgage and the rate changes (during the annual adjustment period), make sure that the conversion is correct for the new rate. These calculations are complex, are often incorrect, and you could be overcharged by the bank.

Rates are low right now. Should I lock in the rate for my new loan, or refinance my old mortgage?

If anyone tells you they know the answer to this question, don't believe them. It is next to impossible to predict with any degree of accuracy where rates will be in the future. It's like trying to predict the weather next month.

Keep the big picture in mind: Rates are low relative to levels five years ago. If you are buying a home and need to decide whether to lock in the rate, look down at your running shoes and get inspired to "just do it". Often, the human nature to be greedy and wait for the "best time" provides little or no reward.

The decision to refinance is, however, another kettle of fish. That's because you already have a mortgage and can compare that rate to current rates. Most folks have already taken advantage of the low rates over the last few years, but there are still a few folks out there who haven't. In fact, the Mortgage Bankers Association reports that 36 percent of today's mortgage applications are for refinancing. The rule is that you should consider refinancing if the new rate is 1.5 percent to 2 percent points lower than your old rate. Here's an explanation:

Current rates for 30-year fixed-rate mortgages are about 7.3 percent. That's almost 1 1/2 percentage points lower than the highest level over the last year. If you have missed a refinancing opportunity two years ago, this would be a good time to consider refinancing again.

The obvious advantage of refinancing to a lower rate is a lower monthly payment. The downside is the cost of processing a new mortgage. If the advantage (lower payments) outweigh the downside (the costs) in a relatively short period of time, refinancing is a good idea.

For example: Monthly payments for a $100,000, 30-year fixed-rate mortgage at 8.75 percent is $787. At 7.3 percent, the payment is $686, or a savings of $101 per month. On average, closing costs for this loan would be about $1,500. Therefore, the $101 monthly savings takes about 15 months to cover the cost.

Adjustable-rate mortgage holders may have another option that lets them take advantage of low fixed rates. It's called a conversion feature. Call your mortgage company (or find out the hard way - read your mortgage) to find out if your mortgage includes this feature; most do.

Ask about the "conversion rate". This rate may be significantly lower than your loan's lifetime maximum rate and slightly higher (1/4 percent) than current rates for new loans. There may be a small administrative fee to use this feature (about $250) but compared to the several thousand dollars you'll fork over for closing costs for a new mortgage, the saving could be worth it. And this could be even more valuable if your mortgage is assumable - the low fixed-rate assumable mortgage could be an attractive selling feature in the future.

Since rates are low, should I consider refinancing to a 15-year mortgage?

You generally can borrow for any amount of time up to 30 years. Most loans are for 15 or 30 years. The shorter the better, but shorter means bigger monthly payments. Many 15-year mortgages offer slightly lower rates, but since you're repaying the principal in half the time, the payments can generally be $200 more per month for each $100,000 borrowed.

The interest saved over 10 years for a 15-year mortgage at about 7 1/2 percent is approximately $13,200, which is significant. The 15-year mortgage is an attractive option for individuals who are refinancing a higher interest rate 30-year mortgage. That's because the increase in the payment (due to the shorter payment schedule) is offset by the decrease in payments (due to the lower rate).

Often, a home owner with a higher interest rate 30-year mortgage can refinance to a lower interest rate 15-year mortgage with a small increase in their monthly mortgage payments, giving them the assurance that their house will be paid off in 15 years instead of 30. (Wouldn't that be great?)

An attractive alternative to this is to refinance the mortgage without changing the term. However, apply the savings realized by lower payments to your mortgage principal balance, in essence creating your own shorter-term mortgage. The advantage is that if your cash flow gets tight, you can always back off the additional payments. That's an option you won't have with a 15-year mortgage.

Points
Points are confusing to most borrowers, but they are actually relatively simple in concept.

Points represent interest paid to the lender in advance.

One point of the mortgage is exactly 1 percent of the amount borrowed.

Banks charge points in exchange for offering a lower mortgage interest rate.

Generally, borrowers should avoid paying points on loans, because they are paying interest up front with no assurance that they will stay in the home. (You could move, for instance, or sell the home.)

Often, consumers wonder if a lower mortgage rate with points is a better deal than a higher mortgage rate without points. The answer is simple: They are exactly the same except for the fact that the points represent an upfront profit for the bank.

Generally, at today's rates, the lower monthly payment (due to the lower interest rate on a mortgage with points) would take approximately six years to equal the points paid when compared to a mortgage payment without points.

When deciding when or whether to pay points, ask to be shown the following: Monthly payments for the mortgage with and without points, and total interest paid over 10 years for the life of the mortgages with and without points.

Remember this: Most mortgages are only eld for an average of seven years. That's because most people either sell the house, move, or refinance the mortgage.

Closing costs
Whether you are getting a new mortgage or refinancing an existing one, there will be "closing costs." These are the costs passed on to the borrower for processing the loan, which include: Attorney's fees, appraisal fees, loan application fee, etc.

There are two rules when mortgage hunting: Get the lowest rate possible (without points) and avoid most closing cost "extras." Unnecessary closing costs include application fees, credit report fees in excess of $45, appraisals fees in excess of $200, and attorney's fees in excess of $300. Remember that a lender will present a menu of closing costs or even ranges for each of the costs. You should ask for each of these to be itemized and specific dollar amounts to be listed for each. A little negotiating enthusiasm will result in a waiver and/or significant reductions of many of these costs. The mortgage market has become very competitive and lenders are eager to secure your business.

Mortgage brokers
A common question is whether to use a mortgage broker or a bank when shopping for a mortgage. As the name suggests, mortgage brokers represent many lenders, sometimes as many as 30 or 40, with names you may never have heard of.

The rule here is to shop both banks and brokers. Remember that your objective is to secure the lowest rate without points, and rates between banks, lenders, and mortgage brokers can vary as much as one percentage point.

Banks and mortgage brokers offer essentially the same services: Pre-qualification for a mortgage, mortgage affordability calculations and application processing. Mortgage brokers give borrowers the perception that the broker is shopping all possible mortgage products available in the market in providing the lowest rates of the day. This is not always the case; often the difference in rates between mortgage brokers can be significant, so shop around.

If you have a computer, I recommend checking out the website HSH Associates (http://www.hsh.com). I logged onto this site for a few hours, tested their home affordability calculator, and checked out the mortgage brokers and rates provided. This was quite entertaining for a financial nerd like me. There is a lot of information on this site and the calculators are generally sound.

Decision Time to Refinance?
If you have a mortgage, now may be the time to consider refinancing. According to the latest study from HSH Associates, most of the drop in mortgage rates has already happened. Also, when rates were lowered in 1998, two of the three rate drops were followed by a RISE in mortgage rates.

Now could be decision time if you are considering locking in a rate on a new mortgage or refinancing a prior mortgage. You'll save about $69 a month for each $100,000 mortgage refinanced at one perent lower than your current rate. (Cha-ching!)

Go With Fixed Rates
If you took out an adjustable-rate mortgage two to four years ago, call the lender and find out when and how much the next rate adjustment will be. Start shopping for a fixed-rate mortgage now as the difference between fixed and adjustable rates is not enough to justify an adjustable rate.

Leverage Home Value to Save Money
There is a bright spot for home owners. Falling rates will help hold up home values as lower rates attract more potential buyers. If you paid mortgage default insurance (called PMI) because you financed more than 80 percent of your home several years ago, call your lender and ask about a new value assessment. With a little appreciation and some principal paid off, your home's value could be enough to exceed the limits, allowing you to ask the lender to cancel the PMI and saving you money. This move can typically save $30 to $60 a month. (Cha-ching!)

No More Jumbos, Please
Also, refinancing may save borrowers who paid higher rates on mortgages that in the past just exceeded the jumbo mortgage limits. The jumbo mortgage limit increased this year to $275,000 from $252,000 in the last year. If your mortgage is just over the new limit, consider using some cash from a year-end bonus or investments to pay it down and refinance into a new mortgage. Refinancing to a conforming mortgage (jargon for non-jumbo) could save you an additional 0.5 percent, or about $95 a month on a $275,000 mortgage. (Cha-ching!)

©MMI, CBS Worldwide Inc. All Rights Reserved