Time to Refinance? Low Rates Are Just One Factor

NEW YORK (Main Street) -- With mortgage rates setting record lows, refinancing has an obvious appeal to any homeowner who passed up earlier opportunities. In fact, refinancing could make sense even for those who got their current mortgage as recently as a year ago.

Today, the 30-year fixed-rate loan charges a mere 4%, according to the BankingMyWay.com survey. It was 5% this time last year.

So, should you take the refi plunge?

At first glance, the refi decision seems cut and dried. If you'll have the loan long enough for its lower payments to offset the refinancing fees, it will pay. But the rigid mathematical approach doesn't always fit real life. Refinancing may be a good bet even if the numbers don't say so, or a bad bet even if they do.

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That' s because refinancing calculators require a certain amount of guesswork. No one knows, for example, what tax rates rates will be in the future. And, of course, if your crystal ball said mortgage rates would drop even further, it would pay to wait.

Most important: No one really knows how life will change the most critical factor in the decision: how long you'll stay in the home.

Consider a homeowner only 12 months into a $300,000 fixed-rate 30-year mortgage charging 5%. Refinancing the $295,574 balance with a new 30-year loan at 4% would pay for itself in 22 months under the most conservative calculation, according to the Refinance Breakeven Calculator. This assumes a 25% federal income tax rate and $3,756 in closing costs for a loan charging zero points, or upfront interest charges that reduce the loan rate.

Most people have a pretty good idea whether they'll stay in their home for the next two years, so this refi looks like a pretty good bet.

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But suppose you wanted a rock bottom rate. By paying 1 point, equal to 1% of the loan amount, you might get a rate around 3.875%, but increase your closing costs to $6,711, and extend the breakeven time to 37 months from 22. Stay in the home longer than 37 months and the points would definitely be a good investment, cutting interest costs by about $8,000 over 30 years compared to the 4% loan.

But the longer the breakeven time the more likely something unexpected will happen. People get married and start families, requiring bigger homes. A job is lost or a new one found. A divorce forces a home sale.

So if the unexpected does happen, would that make the decision to pay points a terrible mistake?

Not necessarily. Though you'd have paid $2,955 more in closing costs because of the 1-point charge, the monthly payment would have been $1,390 instead of $1,411 with the 4% refinancing. If you stayed in the home for, say, 24 months, the lower payment would save you $504. Also, the lower-rate loan would pay down the debt a tad faster, for another $225 in gains over 24 months. So the "loss" from paying points and moving too soon would total $2,226, not $2,955.

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That's too bad, but probably not enough to ruin your life. And if you did keep the loan for the long term, as expected, paying for the rock-bottom rate would make sense.

Bottom line: Any mathematical calculation is only as good as the assumptions put into it. In refinancing, it pays to play with the numbers and look deeply into the results to see whether the cost of making the wrong assumptions is really enough to sway your decision.

Also, it's critical to shop around for a loan that offers the best combination of low rate and low fees. With a shorter time horizon, you are less likely to save money by paying higher fees to get a lower rate.

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