When Is The Right Time To Refinance?

By: Peter Miller
Submitted: 2007-01-17 16:16:08
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One of the great mysteries of our time concerns the matter of when to refinance. It used to be that borrowers would refinance only when rates fell by 2 full percentage points, a standard which makes no sense in today's marketplace.

Now you can refinance quickly at almost any time: No less important, refinancing no longer takes a ton of cash.

It was in June 2003 when mortgage rates hit a low not seen in decades: 5.21 percent according to Freddie Mac. In the first quarter of 2006 rates are roughly 1.25 percent higher, a big difference in terms of monthly payments.

Refinancing when rates are falling is easy to understand, but why refinance when rates are rising?

The answer works like this: Some borrowers should refinance in full, some should refinance in part and some should not refinance at all. The trick is to know which option best meets your needs.

If you were fortunate enough to finance or refinance with a fixed-rate mortgage in the summer of 2003 or thereabouts you certainly want to hold onto such debt for as long as it makes sense. However, there are situations where even borrowers with loans at great rates should look at refinancing options.

Cashing-Out

According to the National Association of Realtors, a typical home cost $165,400 in 2003. As of January 2006, that same home was worth $211,000 -- an increase of $45,600.

Growing home values tell us two things: First, if you want to refinance you likely have far more equity then even a few years ago. Second, that additional equity means you can get a lot of cash from your home without touching your current loan. This is great news if you have low-rate financing you don't want to touch.

Go back to that 2003 home. Imagine it was bought with 5 percent down. That means a $165,400 house was financed with $8,270 in cash and a first mortgage worth $157,130. At 5.5 percent interest, two years later the loan balance has been reduced to $152,585. If the house is worth $211,000 today then the available equity is roughly $58,415.

You could get cash out of the house by getting a new loan for $211,000. However, if you refinanced for $211,000 it means the old loan would be paid off and replaced by a new loan at a higher rate. That's not good.

The better choice is this: Get a fixed-rate second loan or a home equity line of credit (HELOC), a form of financing which usually involves an adjustable interest rate. Such additional financing leaves the first loan in place and untouched. By getting a second mortgage you hold on to the old loan and its low rate plus you get additional cash.

The other attraction of second mortgage loans is that they are often available with little or no cash out of pocket. This is not to say such loans are "free" or nearly free, instead what happens is that the lender pays most or all closing costs.

In exchange for closing help the mortgage lender charges a somewhat higher rate. In addition, loans that require little or no cash up front often have a pre-payment penalty. If the loan is refinanced with another lender or the property is sold within two or three years then a penalty may be due. Ask lenders for specifics.

Safeguarding the Future

It may be that your current financing has a low interest rate or a small monthly payment -- for the moment. But borrowers with interest-only loans, option or flexible ARMs, or loans that convert from a fixed rate to an adjustable-rate mortgage after three to five years should be checked for potential payment shock.

In other words, a 5/1 ARM may have allowed you to acquire a property that has appreciated in value -- a property that could not be financed at the time with a fixed-rate loan. Because you could get the loan you could get the property. In turn, because the value of most homes has risen substantially in the past five years, getting that 5/1 ARM a few years ago has greatly increased your net worth.

But the loan which was terrific a few years ago, the loan that was the right financing at the time, may soon become overly expensive if rates go higher. In such circumstances, refinancing now to a fixed-rate loan can be the smart move to defend your finances.

Consider a $300,000 two-step ARM made a few years ago. There's a 5.5 percent start rate that lasts for five years then the loan converts into a one-year ARM for the remaining 25 years of the loan term.

The monthly cost for this loan during the first five years is $1,703.37 for principal and interest. In year six, let's say the new rate is 6.50 percent and the mortgage balance has been reduced to $276,949.78. The new monthly payment for principal and interest will be $1,869.98.

Is the higher monthly cost a problem? If your income has risen over five years, then no. But what if rates go higher than 6.5 percent? At 7.5 percent -- not a high rate by the standards of the past 25 years -- the monthly payment will be $2,046.63 for principal and interest. Insurance and taxes are extra, of course.

Like cars, loans are bright and shiny when new but they can become outmoded over time. At the very least, it's appropriate to see if the loan that worked so well a few years ago is the right loan for today -- or for tomorrow.

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Peter G. Miller is a syndicated real estate and personal finance columnist who appears 70 newspapers.

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