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Will you save in the long run? Refinancing 101

Today’s low interest rates may look tempting, but how do you know if refinancing is really worth it? The ABCs of refinancing include knowing how to shop for a deal, knowing what to expect in closing costs and fees, and being able to figure out if you’ll really save money in the long run. Here’s everything today’s homeowner needs to know to take advantage of record-low interest rates.

Refinancing is basically taking out a new loan to replace an old one, and typically comes with all the expenses that go with a new loan. Before you refinance you should be sure you’ll really be accomplishing your financial goals. Here are the questions to ask:

1. Why should I refinance?Refinancing doesn’t reduce your debt, it just restructures it, so be clear about what you want to achieve with a refi. You can:

  • Lower your monthly mortgage payment. With mortgage rates at or below 5 percent, you have an opportunity now to lock in a lower rate of interest on your loan and, as a result, lower your monthly payments.

  • Shorten your mortgage term. Especially if you’re over 40, shortening the term of your loan to pay it off sooner could make you mortgage-free in retirement.

  • Get needed cash. With cash-out refinancing, you take on a new mortgage greater than the amount of your previous mortgage and use the cash difference to pay current expenses. But this typically comes at a higher interest rate.

  • Consolidate your debt. If you have a first mortgage and a home equity mortgage, you can combine both into one fixed-rate mortgage.

2. Can I refinance?Whether or not you’ll even be able to refinance depends on several factors.

  • Your loan-to-value ratio. In other words, this is the amount of equity you have in your home compared to the current value of your home. As long as your existing mortgage is less than 80 percent of the value of your home (75 percent if your home is a condo or co-op) you’ll have refinancing options. If you owe more than that amount or are underwater, you should look into the government’s Making Home Affordable program as you might be eligible for a government loan (www.makinghomeaffordable.gov).

  • Your home’s value. Most single-family homes today need to conform with Fannie Mae and Freddie Mac limits, up to $417,000 in most areas and up to $729,750 in high-cost cities like New York and San Francisco. Amounts above that are considered “jumbo” mortgages and are very hard to get.

  • Your credit score. These days a credit score of 740 or above gets you the best loan terms. With a score below 620 you’ll be hard-pressed to get any loan unless it’s FHA/VA. Credit-reporting companies all use different formulas to determine your FICO score. You’re best paying to get your scores from TransUnion and Equifax FICO through MyFico.com. It’s very close to the score your lender actually will use. And of course keep track of your credit by checking your free credit report from all three bureaus once a year at www.annualcreditreport.com.

  • Paperwork. Banks want a lot more info than they once did before granting a refinance. Get ready by collecting your pay stubs, bank statements, brokerage statements and your tax returns.

3. Should I refinance?Refinancing your mortgage usually makes sense if you can lower your interest rate by at least two points. But the most important question to ask yourself is, how long will it take you to break even?

  • Determine your break-even point. Add up the points and other costs to close your new loan, and divide it by the amount you’ll save on your mortgage each month after financing. This tells you how long it will take to break even. If you can recover your costs in two or three years, and you plan to stay in your home longer, refinancing could save you a bundle over time.

    Example: If you’ll save $100 a month on a $200,000 mortgage, and your cost to refinance is $3,200, you’ll break even in 32 months.

  • Changing the term. If you get a new 30-year mortgage several years into your original mortgage, you’re essentially lengthening the term of your loan, and that can cost you plenty. It usually makes more sense to shorten the term of your loan.

    Generally you want to avoid going backward. Instead, get a 15- or 20-year fixed rate mortgage. Or consider applying the amount you’ll save per month to paying down your principal, which will reduce both the term of your mortgage and the total interest you’ll pay.

    Example: If you have a $200,000 mortgage at 6 percent with a monthly payment of $1,199, after 6 years you’ll have paid $69,131 in interest. If at that point you refinance your remaining $182,796 principal into a 30-year fixed mortgage at 5 percent, your monthly payments will drop to $981. But over the life of the new mortgage you’ll pay $170,468 in interest. That means your total interest will amount to $239,599 ($69,131 + $170,468), as opposed to a total $231,676 if you’d stayed with your old mortgage. That’s an added cost of $7,923 in interest!

  • How long you will be there. If you plan to stay in your home at least another three to five years, when interest rates are likely to be substantially higher, it may make sense to lock in a low rate now.

4. What to watch out for

  • Lenders that promise “no points, no closing costs.” No loan is free. The costs are in your loan somewhere, maybe rolled into the amount to be refinanced or even coming at a higher interest rate.

  • Delays. Even if you can refinance, expect a long wait. Some banks are taking as long as 90 days to complete a refinancing.

  • Pre-payment penalties. If your current mortgage has a pre-payment penalty, don’t forget to factor that into the expense of refinancing.

  • Private mortgage insurance. PMI requirements could add to the cost of refinancing.

  • Co-ops and condos. Lenders are tightening up on the requirements buildings must meet for the occupants to get a loan.

  • Chronic refinancing. Typically you want to refinance only once (if at all) on your current mortgage.

Real estate expert and TODAY contributor Barbara Corcoran was the founder of real estate business The Corcoran Group. To find out more, visit her Web site.

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