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Refinancing: Making the Right Choices

Ideas about When to Refinance and Mortgage Products

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The article below offers ideas about when to refinance and which mortgage products to choose when refinancing.
Many people are considering refinancing their mortgages in order to reduce the cost of their loans. This article discusses when and how to refinance.
These days, long-term interest rates are hovering slightly above 6%. Even though the rates have come up from their historic lows, they are still comparatively low. For anyone with a higher mortgage rate, the market provides a golden opportunity for mortgage borrowers to refinance.

Deciding When to Refinance

The rule of thumb in the 1980s used to be that you should refinance when you can lower your mortgage rate by 2 percentage points. However, today you should consider refinancing whenever rates have declined since you took out your mortgage.
There are two reasons why the old rule of thumb no longer applies:
  1. The level of interest rates is lower than it was in the 1980s. Refinancing from 7% to 6% would give you the same proportionate reduction as refinancing from 14% to 12%.
  2. The costs of originating a loan have fallen. Our refinance calculator evaluates how long it will take you to recover the loan origination costs when you refinance. If you are charged little in points or origination fees, then it takes only the smallest reduction in interest rates to warrant refinancing.
Nowadays, any time you see an advertised rate on a mortgage that is lower than the rate on your current mortgage, you should investigate refinancing. It could be that rates have fallen since you obtained your mortgage. Or it could be that you did not shop as well as you might have when you got your current mortgage.
If you think choosing the time to refinance should be based on whether interest rates are going down or up, there is good news and bad news. The good news is that it is correct knowing where interest rates are headed would help you make the correct refinance decision. The bad news is nobody knows for certain where interest rates are headed (and anyone who claims to know should not be trusted).

Choosing a Loan Product

In today's environment, you may want to avoid adjustable-rate mortgages, or ARMs, that adjust in less than five years. The reason is the maximum amount by which the rate can adjust typically still is 2%, even though rates have come down considerably since the products were first designed. A 2% rate adjustment is proportionately higher now than it was a few years ago (see point 1 of the preceding section).
There are consumers who take out one-year ARMs and refinance them every year, always dodging the rate adjustment. They go for no-point loans to keep their refinancing costs down. This strategy works out well when rates decline, but when rates will go up, these one-year ARM borrowers will have to pay the toll.
One question to ask yourself is whether you can afford the monthly payment on a 15-year fixed-rate mortgage. The monthly payment on a 15-year mortgage is higher than that on most other mortgages, because it is designed to be paid off in 15 years rather than 30 years. However, if rates have fallen enough or your income has risen enough since you took out your current mortgage, the 15-year product may now be affordable for you. You can use our payment calculator to check.
If you cannot afford the monthly payment on a 15-year mortgage, then you need to consider different products. The 5-year balloon, 7-year balloon, and 10-1 ARM products all have merit. The more likely it is that you will be moving in less than 10 years, the more you should lean toward the 5-year or 7-year balloon.
Should you pay points when you refinance? For example, suppose that you can get an interest rate that is 0.5% lower by paying 1.5 points up front. Thus, the payback would be approximately three years: if you keep the mortgage longer than three years, it will be beneficial to have paid the up-front points.
Many people prefer not to pay points. The thinking is this:
Here I am, refinancing today. But what if rates fall again in the next few months? If I pay points now and end up refinancing again soon, then I've just thrown away money.
What is happening here is that all of a sudden, because people are refinancing, their time horizons are very short. However, this may not be entirely rational. Although it is possible you will want to recycle your mortgage again in three months, this is relatively atypical. There is a reasonable chance that you will keep your mortgage for at least three years. If you can get a three-year payback or less by paying points, then paying points up front is an attractive option.
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