Will Refinancing Pay?

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In an old Saturday Night Live gag, the announcer said there’d been no trading on Wall Street because everyone already had the stocks they wanted. At some point, you’d think that would happen to mortgages.

For the week ended Oct. 9, three out of every five mortgage applications involved a refinancing rather than a home purchase, according to Freddie Mac (Stock Quote: FRE). How long until everyone who wants to refinance will have done it? After all, interest rates have been below 6% for most of this year.

The eagerness to refinance in part comes from borrowers switching from adjustable-rate loans they took out several years ago. As low “teaser” rates expire, monthly payments go up, and homeowners switch to fixed-rate loans that may have lower payments right away and don’t carry the risk of higher ones later.

Another reason: Homeowners appear eager to refinance even if payment reductions are fairly small. They seem to have dispensed with an old rule of thumb that said refinancing paid off only if you could reduce your interest rate by at least two percentage points.

Tools like the Mortgage Refinance Break Even Calculator may be playing a role, making it easier for homeowners to figure the savings from refinancing. In many cases it does make sense to refinance even if the rate will drop less than one percentage point, especially if one is getting the added benefit of moving from an adjustable to a fixed-rate loan. (Only 6.2% of recent mortgage applications involve adjustable-rate loans, the Mortgage Bankers Association says.)

The key to any refinancing is whether the new mortgage will be held long enough for the payment reduction to offset the refinancing costs, which can run into the thousands. With the calculator, you can see how, in addition to reducing your payment, a refinancing can help build equity faster, an important factor in the refinancing decision. In addition, the calculator considers how refinancing to a lower interest rate will reduce your federal income tax deduction for interest payments.

Consider a borrower who took out a $200,000 fixed-rate mortgage three years ago at 6.5%, a typical rate at the time. The loan balance, now $192,834, could be refinanced at today’s 30-year fixed-rate average, which is about 5.2%, according to the BankingMyWay.com survey. This would reduce the monthly payment by about $215, and it would take 22 months for that to offset $4,657 in closing costs. Keep the new mortgage longer than that and refinancing makes sense, as you’d save $215 a month, or nearly $32,000 over the life of the loan.

The new loan carries a slightly smaller payment for private mortgage insurance, reducing the break-even point to 21 months. On the other hand, the reduced interest payment means a smaller mortgage-interest deduction on the new loan. Taking that into account, the break-even period becomes 28 months.

Finally, the homeowner has the option of forgoing the refinancing and using the cash for a prepayment on the old loan rather than on closing costs. Since this reduces interest charges on the old loan, making it more competitive with the new one, it lengthens the break-even period to 32 months.

Of course, this is just an example, and you need to key in your own numbers. But there’s a good chance that refinancing would pay off even if the interest-rate cut is not very large. Use the search tool to find the cheapest loan.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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