When Does It Make Sense to Refinance?

Maybe you bought when interest rates were higher. All you could qualify for at the time was an adjustable-rate mortgage (ARM). With today's lower rates, you can qualify for a fixed-rate mortgage, which you'd prefer. One reason to refinance is to change the kind of mortgage you have.

Other reasons to refinance are to lower your monthly mortgage payment, to consolidate several debts (like credit cards) into one relatively low-interest rate loan, and to convert some of the equity in your home to cash to use for other purposes like remodeling or for college tuition.

Whatever your reason, the first thing to think about is how long you plan to stay in your home. If you plan to move soon, and you'll only save $50 or $100 a month by refinancing, it may not be worth it. Multiply the number of months you plan to be in the house by the savings per month. Compare this amount to the fees you'll pay to refinance. If the fees are higher than the cost savings, it's not a good deal.

Homeowners who plan to stay in their homes for 5 years or less, and who want a fixed-rate loan, will probably save money with a 5 or 7-year fixed rate loan. These loans have a lower interest rate than 30-year fixed-rate loans. However, the shorter-term loans are either due in 5 or 7 years, or the monthly payments change from fixed to adjustable at that time. Still, if you have no intention of staying in your home that long, go for the fixed-rate loan with the shorter due date.

Homeowners planning for retirement may want to refinance into a 15-year fixed-rate loan. Lenders usually give a preferential rate on 15-year loans (from .25 to .50 percent less). Also the loan is paid off in half the time so the savings on the amount of interest paid is phenomenal. The total interest paid on a $100,000, 15-year loan at 7 percent is $61,789. On a $100,000, 30-year fixed-rate loan at 7.5 percent, the interest paid is $151,712.

Refinancing to pull cash out of your home should be done with caution. You can get yourself into a bind if you refinance when the value of your home is high. If the market turns down and you have to move, you might not be able to sell for enough to pay back the mortgage.

Most lenders will allow you to refinance and take cash out as long as the new mortgage amount doesn't exceed 75 percent of the appraised value. Also lenders usually don't want the borrower to pull out more than $100,000 cash from the refinance. Exceptions are always possible, but the interest rate will most likely be higher.

Refinancer's Tip: Unless you plan to stay in your home for more than 5 years, it probably doesn't make sense to pay points to refinance. "Points" is the term lenders use for the loan origination fee. One point is equal to one percent of the loan amount.

On a purchase mortgage, the points are tax-deductible in the year you buy your home. This is not so with a refinance. The points paid to refinance must be deducted incrementally over the term of the loan (1/30 of the amount per year for 30 years, or until the loan is paid off).

The Closing: Finally, if you're planning to move within 3 years, watch out for prepayment penalties (in states where they are legal, like California). Some lenders charge prepayment penalties on their zero-point loans.