Is It Time to Refinance Your Mortgage?

If you are a homeowner, the record-low interest rates on home mortgages have probably caught your attention, and the idea of refinancing your own mortgage may be on your radar. This past week, Bankrate.com reported an average of 4.59% for 30-year fixed mortgages. In fact, interest rates for 30-year fixed mortgages are at their lowest level since 1970, according to Freddie Mac (FMCC). These rock-bottom rates have led to the highest demand for home refinancing in 15 months.

Although the declining rates do appear singularly attractive, be sure to have a thorough understanding of what you're committing to before refinancing your mortgage. A good-looking rate should not be your only basis for refinancing, especially because the whens and whys of refinancing your home mortgage are neither straightforward nor cookie-cutter.

Ultimately, a mortgage refinance will make sense for some, but even then, the process will require additional legwork. For others, it will be more sensible to forgo a ride on the refinancing bandwagon and stick to their current mortgages.

Below, we've listed some dos and don'ts.

Do Know Where You Stand
A starting point to help determine whether refinancing makes sense for you is to see where you are now: Know your current loan's terms, including your remaining principal level and the interest rate of your current mortgage as well as whether your current loan has a prepayment penalty. Also get a feel for your current credit standing. Although the lender or mortgage broker will pull your credit report, you can check up on your credit history by using an online service from the government such as AnnualCreditReport, which allows you to request a free credit file from the three major credit agencies. That way you can get a feel for whether you'll qualify for the most favorable interest rate and terms.

Also give some consideration to what your home is worth right now, using the purchase price of homes that have recently sold in your area. It's worth mentioning from the get-go that it may not be a good idea to refinance if your property has depreciated. If your equity in the home has dropped below 20% or has totally evaporated, most lenders simply do not have an incentive to refinance a home that is valued lower than the original price. Government programs, such as the Making Home Affordable plan, may offer help to underwater borrowers, however.

Do Have Your Documents in Order
With the bursting of the housing bubble not too far in the rearview mirror, you may be requested to provide unexpected forms of documentation during the refinancing process.  J.P. Morgan Chase (JPM) offers a list of documentation that you should have with you. Keep in mind that the amount of paperwork needed to process your refinance will vary by lender and your credit score (the worse the credit, the more documentation that will be required).

Do Crunch the Numbers
Sinking rates are obviously a motivator and for good reason: You can save money by refinancing to a lower interest expense. Conventional wisdom applies the "2-2-2 rule" to refinancing: Refinancing makes sense if you have been living in your house for two years, are planning on staying there for another two years, and the new rate is two points lower than your current mortgage rate.

However, rules of thumb like this one are often misleading because they do not apply to all scenarios. For example, interest rates will vary dramatically depending on your credit history, current loan terms, and how much you've already paid on your existing mortgage. Using a calculator to input conditions that are specific to you will be a more helpful guide than following any one rule of thumb. Use this BankRate calculator to input the loan term and interest rate of your intended refinancing. Compare the projected monthly payment with your current monthly payment to determine your savings.

If you can swing it, you might consider shortening the term of your loan to obtain an even lower rate; a mortgage calculator can help you compare your current loan payment with the payment on a shorter-term loan. On the flip side, be careful about lowering your rate by switching to a longer term--for example, opting for a 30-year loan rather than sticking with your current 20-year term. While lengthening the term of your mortgage can result in a lower payment, extending the mortgage term is likely to cost you more in interest over the life of the loan. That may be a worthwhile trade-off if you're in a serious cash crunch, but proceed with caution.

Do Shop Around for Lowest Rates
Don't assume that bigger institutions always offer the lowest rates. Regional lenders and independent mortgage brokers can help you find rates that are lower than the ones that the top three lenders are offering: Chase,  Wells Fargo  (WFC), or  Bank of America  (BAC). Investigate whether a lender in your area offers a better interest rate. Even if you are planning on hiring a broker, doing your own research and being well-informed of the rates that are currently out there puts you in a favorable position to spot discrepancies in the rates that brokers offer.

Do Refinance If You Are Planning to Keep Your Property Long Term
Refinancing multiple times can bring down your interest rate, but it also leaves hefty closing costs in its wake. According to LendingTree, a homeowner should project about 3%-6% of the total price of the home in settlement costs including taxes. This figure does not include any prepayment penalties, and the costs of any second mortgages that may exist. Ask yourself how long you plan to keep your property. Then, consider how many months of lower payments it will take to recover the closing costs of the new mortgage in comparison with how much your monthly payments decrease.

A note about closing costs: Federal law requires lenders to provide borrowers with a good faith estimate of settlement charges three days after they apply for a loan. However, lenders can charge fees that vary up to 10% from levels quoted in the GFE and still comply with the law, so it is important to stay on the offensive as you compare closing costs among different lenders. Insist on an estimate of the closing cost even if lenders seem unwilling to disclose those numbers. Don't hesitate to question lenders about fishy line items marked by vague terms such as "underwriting" and "application" fees which may be alternative names for services for which you are already paying.

 

Do Refinance for Stability
Borrowers who seek stability are increasingly ditching their adjustable-rate mortgages for fixed loans. If the prospect of fluctuating mortgage payments gives you heartburn, the certainty of locking in a fixed rate might be what you need.

Do Refinance to Consolidate Your Mortgage and Debt
Although adding to your principal level is far from ideal, using home equity to pay down more costly forms of debt can be a prudent financial move. Not only will you be able to obtain a lower rate on your mortgage than with other types of consumer financing, but unlike other consumer debt, mortgage interest is tax-deductible. By using a cash-out refinance, the new loan balance will consist of the current loan balance plus the desired cash-out amount. Say that your home is currently valued at $400,000 and your loan balance is $300,000. This means that you have $100,000 in equity and own 25% of your home. If you want to add a $20,000 cash-out in addition to your original $300,000 balance, your new loan amount would be $320,000.

Such cash-out loans were at the epicenter of the crisis, so keep in mind that lenders will make you jump through some hoops to arrange this type of financing. For example, most lenders require you to have owned your property for a least a year before they permit you to take out additional cash. Also note that when you cash-out, you reset your mortgage by taking on more debt and lose the equity that you may have spent years building. Reserve this option for emergencies or when interest rates are too low to pass up. As always, be sure to understand the restrictions and any costs involved before executing a cash-out refinance.

Don't Refinance if You've Been Paying Off Your First Home Mortgage for a Long Time
If you are almost finished paying off a 30-year fixed mortgage, then refinancing is probably not a good idea. A new loan will most likely put you in deeper debt by extending your loan term just as you were about to become debt free.

Don't Refinance if You've Used Up Substantial Equity
Refinancing is not a good idea if you have already tapped into your equity aggressively. You would usually want to refinance when you have built up at least 10% equity in your home, though most lenders consider 20% a threshold for obtaining the best terms for refinancing.

Don't Refinance if There Is a Prepayment Penalty on Your Mortgage
Waiting out the period during which prepayment penalties apply leads to more cost-effective refinancing, though you are risking higher interest rates at the end of the penalty period.

Don't Refinance if Your Credit History Is Suffering
At the risk of stating the obvious, getting your credit history and credit score in the best possible shape will also land you a better mortgage rate. The best rates are only available to people with spotless credit profiles: high credit scores without any negligence on record. Most lenders prefer that you have no late payments in the last 12 months before you refinance.

Don't Be Afraid to Seek Help if You're in Real Trouble
In February 2009, the Obama administration introduced the aforementioned Making Home Affordable plan to stabilize the housing market and help struggling homeowners avoid foreclosure. The program helps responsible homeowners willing to make payments to stay in their homes by decreasing their monthly payments to as low as 2% and extending repayment periods for as long as 40 years. Despite its noble intentions, the program has had mixed success to date. More than one third of the 1.24 million participants who enrolled in the program have already dropped out largely because of their inability to provide proof of income or to keep up with the monthly payments.

Check out the Making Home Affordable website for more information about the specific programs that are offered.

Don't Shun Professional Help
Although you can handle many parts of the refinancing process on your own, you may need a professional broker or financial advisor to untangle some of the more complicated issues that may arise--if you have multiple properties, for example, or an unfavorable credit history. Until then, take advantage of the many online resources that major banks and lenders offer to help facilitate the process of refinancing your mortgage. Also, check out the various refinance calculators available at BankRate and LendingTree to help you outline a plan that will best accomplish your goals.