It's Time To Refinance...Again

Less than a year after refinancing his Encino (Calif.) home, Larry Levine went shopping for a better deal. With mortgage rates at their lowest point since flower children and the original Volkswagen Beetles roamed the earth, the restaurateur snapped up a 30-year, fixed-rate mortgage in September at 6.625%, shaving 1 percentage point from the interest rate on his $300,000 loan. He rolled several thousand dollars of closing costs into his new mortgage, so he only had to spend a couple hundred upfront for an appraisal. His monthly savings? More than $200.

As mortgage rates decline--reaching a 30-year low of 6.49% in early October before edging back up within a week to around 7%--they are triggering the decade's second major refinancing wave. Running at about twice their normal pace, refinancings are expected to account for about half of this year's $1.4 trillion market for mortgages, says the Mortgage Bankers Assn.

SEESAW. Should you join Levine and the crowd of other Americans now refinancing? With financial market volatility high and mortgage rates seesawing off record lows, it's tempting to try to snag the cheapest deal possible. Indeed, the Federal Reserve's surprise interest rate cut on Oct. 15 has already sent 30-year mortgage rates back down slightly. Even with their current volatility, however, mortgage rates remain cheap--and their short-term swings hard to predict. "I would lock in and not gamble," advises David Lereah, the MBA's chief economist. Adds Keith Gumbinger, vice-president at HSH Associates in Butler, N.J.: "Anyone with a mortgage rate above 8% should at least be running the numbers."

The windfall for U.S. homeowners comes courtesy of financial turmoil in Tokyo, Moscow, and Sao Paulo that has sent investors scurrying for the safety of U.S. Treasury bonds. Interest rates, which dip as bond prices rise, have hit record lows. But mortgage rates have not fallen as far as the 10-year Treasury notes they track because investors who buy the loans in the secondary market are demanding greater compensation to pass up the safety of Treasuries.

The decision to refinance often comes down to knowing you will keep a loan long enough to recoup upfront refinancing costs. To calculate a break-even point, divide closing and other refinancing costs by the aftertax savings on monthly payments. Say you're in the 28% tax bracket. If a new loan saves $140 monthly before taxes, it will net you $100 after taxes per month. If your refinancing costs $4,000, it will take 40 months before any real savings begins.

If you plan to sell or refinance again before the break-even date, try for a no-cost loan with no out-of-pocket expenses, closing costs, or points--the fees paid upfront in return for a lower rate. Typically, no-cost mortgage rates are a half percentage point above those on standard mortgages. Another way to avoid upfront costs is to roll the closing costs into the loan balance. If your costs are $5,000, you would be borrowing that much extra and paying interest on it. But you get to hold onto your cash, and the extra amount you finance will add little to your monthly payment.

A less obvious way you can save on refinancing is with an adjustable-rate mortgage (ARM). Favored when interest rates are high, they are not in fashion in this era of low inflation. ARMs come in a variety of shapes and sizes, but most guarantee a set rate for up to 10 years at a slight discount to the fixed, 30-year rate. After that, rates fluctuate with an index, exposing borrowers to the risk of higher payments. "It's hard to get excited about anything but fixed-rate mortgages these days," Gumbinger says. But if you think you're going to sell before your rate starts floating, an ARM might be worth considering. In mid-October, you could find a one-year ARM at 5.56% and a 10-year at 6.7%.

If you're determined to get a fixed-rate loan, don't be fooled by low advertised rates. When you take fees into account, a 7.5% loan from one bank might actually be cheaper than a 7.125% loan from another. Robert Heady, author of The Complete Idiot's Guide to Managing Your Money (MacMillan General Reference, $16.95), recommends requesting written estimates of such fees as closing charges and interest expenses over five years, a common length of ownership. "Add those together, and your best deal will show itself," he says.

You can also trim fees with a "streamlined" refinancing, now offered by many lenders. At Norwest, current mortgage clients can save an average of $350 and 30 to 40 days by skipping steps such as the credit check and appraisal.

Lower fees are not the only way to save. Like Levine, a growing number of homeowners are enrolling in prepayment penalty plans. Levine gave up the right to refinance over the next five years, saving about 20 basis points on his loan. If he changes his mind, he will have to pay his lender, Headlands Mortgage, six months of interest as a penalty. But with rates so low, Levine figures he is unlikely to refinance again. "I'm done for life," he says.

Low mortgage rates have also breathed new life into "cash-out" refinancings, in which homeowners trade in old mortgages for new ones with larger balances. You can use the cash to pay off high-interest debt, fix your house, or pay for college, but there are risks. If paid back over 30 years, the extra borrowings run up a much higher interest tab than a shorter-term debt. And spending home equity jeopardizes a crucial retirement and emergency resource.

Even riskier is an interest-only mortgage. Under a plan offered by Mellon Bank's Boston Co., clients pay nothing but interest for the first decade of a 30-year loan. The rates are fixed at first and then variable, but the initial savings can be substantial. At a fixed rate of 6.5% for five years, the monthly payment on a $600,000 interest-only loan is $3,250, vs. $4,093 for a 30-year loan at 7.25%--a difference of $10,117 a year for five years. Once the interest-only option turns variable, you risk having to pay a much higher rate.

Typically, the interest-only option is restricted to holders of jumbo mortgages over $227,150, who use the savings to offset the extra half point they are often charged. In recent years, many borrowers have funneled these savings into stocks. As the market's travails illustrate, the tactic can backfire. "It's a great idea if you're a great investor," says Roger Harrington, a mortgage adviser in White Bear Township, Minn. He also counsels against taking out shorter mortgages in favor of a 30-year loan. With the lowest monthly payments, a 30-year mortgage leaves more cash for investing.

But if you're the type to fritter away extra cash, you're a candidate for the discipline a 15-year loan imposes. These shorter loans save thousands in interest costs (table). While monthly payments run about 20% above those on comparable 30-year loans, today's low rates make them more affordable.

If your goal is to prepay your loan, avoid programs that charge you to do so. "Accelerator accounts" impose fees in return for accepting the equivalent of 13 monthly payments. "It's nothing that an individual can't do for himself," said David Walz, a fee-only planner in Oak Park, Ill.

Whether you prepay or stick with your loan for years, today's low rates offer lots of savings opportunities. "This historically low mortgage rate comes once every two generations," says the MBA's Lereah. So grab your calculator and start crunching numbers.

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