When is it Worth it to Refinance?

Like many homeowners, you have owned your home for a few years and have maintained a good mortgage payment record. You think you got a pretty good deal on your interest rate, but when mortgage interest rates fall below your current rate, you wonder if and when it is worth it to refinance and get a lower interest rate.

You know that there are costs involved when you refinance, but the process seems complex and you're not sure where to start. Fortunately, there are resources available to make the decision easier, and you can do the math before you pick up the phone to contact a mortgage provider.

Your Loan: Adjustable Rate Mortgage (ARM) or Fixed Rate?

The first question you should ask yourself is whether your mortgage is an adjustable-rate mortgage (ARM) or a fixed-rate. If you have an ARM, your rate may be low, but it will change. Not if, but when. Within defined limitations (or "caps"), your lender has the right to change your rate relative to a financial index. Caps typically are defined by the allowed frequency of the interest rate change, the periodic change in interest rate, and the total allowable change in the interest rate over the life of the loan (the "life cap").

Lenders frequently offer low initial ARM rates and then raise the rates overtime. Historically, mortgage rates have been as high as 15%. Are you ready for that? If you have an ARM, you owe it to yourself to convert to a fixed-rate mortgage as soon as possible.

The Costs Associated With Refinancing

Refinancing your mortgage is just like taking out a new mortgage. When deciding whether it is worth it to refinance, remember that most of the costs are the same, and your credit rating will be a factor. Here are the basic closing costs you may need to pay:

• Points

• Application fee

• Attorney's fees (yours)

• Attorney's fees (lender)

• Title search

• Appraisal fee

• Local fees, taxes, transfers

• Credit check

• Inspections

• Document preparation

It is easy to assume that if your current rate is 6.5% and you can refinance to 6%, it will be worth it to refinance. Maybe, maybe not. Aside from the additional closing costs listed above, you need to take into account the balance left on your mortgage, your current monthly payments, and the projected payments at the new rate. These have to be weighed against the upfront cash cost of refinancing.

Amortization

One key element to consider is amortization. This refers to the shifting ratio of interest to principal that you are paying on your mortgage over time. During the first few years of your 30-year mortgage, you are paying mostly interest. Up to 85% of your monthly payments will be applied to the interest, not the principle.

For example, if your loan amount is $200,000 with a 7% interest rate, over the first three years you will make over $48,000 in payments. But at the end of three years your balance won't be $152,000; it will be $193,000. In three years you will have paid down your principal by only $7,000. It is only after you've been paying for 20 years do you start paying proportionately more in principal than interest.

If you have been paying for three years and you refinance, you will probably start all over again with a 30-year loan for $193,000, plus the costs. Most of your payments will be applied to the interest.

Before you sign on the dotted line, do the math. There are plenty of websites with refinancing cost calculators, or you can visit the U.S. Treasury Department website.