4 good reasons to refinance now

Mortgage rates are going up and some homeowners who were thinking about refinancing this summer may have missed the boat.

Our most recent survey found the average rate for a 30-year fixed-rate loan is now over 6.6%. A search of our extensive database of the best mortgage rates from across the country shows that even the most qualified borrowers will now pay 6.375% or 6.5% for such a loan unless they want to pay thousands in fees.

But if you have an adjustable rate mortgage, that's going to reset, or are thinking about taking some cash out of your home, now's the time to act. Some economists are expecting 30-year fixed-rate mortgages could average 7% by the end of the year.

Indeed, there are four good reasons to consider refinancing now:

  • You're paying 7.5% or more on any kind of mortgage.

  • You have an ARM that has recently reset or is going to over the next year. This is especially important if you've been enjoying an introductory rate of 4% or 5% and you'll soon be paying 7.5%, 8.5% or more. Just be sure either you don't have a pre-payment penalty clause in your mortgage, or it's one that you can handle.

  • You have significant equity in your home and can use a cash-out refinancing to make improvements or payoff high-interest credit card bills. This is still a cheaper way to get that money than a home equity loan or line of credit.

  • You can afford higher monthly payments. Swapping a 30-year loan for a 15-year loan will save you a pile of money in the long-term.

Although rates are important, the key to a successful refinancing is to be sure that you stay in the house long enough to recover the cost of a new loan.

If, for example, refinancing cuts your payments by $100 a month, but you paid $2,000 in closing costs to obtain the new loan, you would have to live in that house for 20 months before you actually begin saving.

With that in mind, take a look at your mortgage and see if refinancing can:

Lower your monthly payment.

An old rule of thumb says that you shouldn't refinance unless you can save two percentage points on your mortgage rate. But if you can save even one percentage point, you're throwing money away every month by not refinancing.

If, for example, you have a mortgage for $165,000 at 7.5%, you're paying about $1,154 in principal and interest each month. Refinance to 6.5% and you'd be paying $1,043 a month. That's $1,332 a year less, or $6,660 less over five years.

Now subtract the cost of the refinancing, let's say $1,000, and you'd still save $332 in the first year and $5,660 over five years.

Consider the same loan with only three-quarters of a point rate reduction. A 30-year loan at 6.75% would cost $1,070 a month in principal and interest, saving $84 a month or $1,008 a year.

If you can get a new loan cheaply enough-fees of $1,000 or less -- that's still a good deal. You would probably save enough to pay off a credit card or do some much needed home repairs.

Get you out of an increasingly expensive adjustable-rate mortgage.

Many borrowers over the past few years were given artificially low introductory or "teaser" rates on adjustable-rate mortgages. If that rate is about to end -- or has already ended and begun to rise -- you should refinance.

While that initial rate was probably less than you could get on a fixed-rate loan, the new rates will be higher.

That's because lenders determine how much they charge on an ARM by taking a benchmark interest rate -- such as what the government is paying to borrow money for a year -- and adding a premium or margin. If your credit is good, that might be 2.5 percentage points. If your credit isn't so good, it might be as much as 7 percentage points. (If you're unsure about your loan, check the mortgage documents. The formula is spelled out in there.)

Even with good credit, many ARMs are adjusting to more than 7%. Some loans may take a couple of years to get there because they have a cap that limits annual increases to 2 percentage points. But that's where they are headed.

Although you might want to refinance to a 30-year fixed-rate loan, the lower your credit score the more difficult it will be for you to qualify. Borrowers with credit scores below 620, who must apply for high-cost subprime loans, will have the toughest time.

Lenders will want documents that verify every aspect of an application, especially your income and assets, something they frequently ignored just six months ago.

They're also demanding that you have at least some equity in the home -- a huge problem for borrowers who put no money down and financed the entire purchase with negative amortization loans that allowed their debt to grow faster than their homes appreciated in value.

To save them from foreclosure, Ohio has a new state-supported program that allows homeowners with little or no equity to refinance into 30-year fixed-rate loans at 6.75%. Other states will likely follow this lead, so ask your lender if he or she is aware of any such programs.

When you refinance avoid especially dangerous loans such as option ARMs or interest-only mortgages, no matter how cheap the initial "teaser rate" or payments might be.

Click here for more advice on what to do if your mortgage payments are going up.

Free up cash from your home.

High on the list of reasons to refinance is the popular "cash-out" refinancing that allows you to borrow more than you owe on your current loan and pocket the difference.

Let's say you owe $100,000 on a $200,000 home. You could refinance for $125,000, pay off the $100,000 balance on the old mortgage and keep $25,000 for yourself. That was an attractive option when you could refinance to a lower interest rate or one that was close to what you were paying. But soon that might not be possible.

With good credit, most lenders will allow you to refinance up to 80% of your equity -- in this case, $80,000. In most cases we do not advise taking 80%, but it's there if you need it.

There are lenders out there who will lend you up to 125% of the value of your home. Bad idea! Suddenly you owe more than your home is worth, making it difficult to sell without coming up with a lot of cash.

According to Freddie Mac, the government-backed agency that buys, packages and resells mortgages to investors, 82% of all the refinanced loans it bought between January and March 2007 were cash-out deals.

Used responsibly, it is often a less expensive way to tap into the equity in your home than by getting a traditional home equity loan or line of credit, which will cost you in the neighborhood of 7.75% to 8.25% right now. But spending that money on home repairs, credit card debt, unexpected medical bills or your kid's college tuition makes good financial sense.

Here's what we consider to be the six best and five worst ways to spend the equity from your home.

Reduce your interest payments.

If you can handle higher monthly payments, you can save in the long run by refinancing into a shorter-term mortgage.

Switching from a 30-year to 15-year loan means your total monthly payments would grow from $632 to $844 for every $100,000 you owe because you'd be paying the principal back twice as fast.

But you'll ultimately save money two ways:

  • The shorter the loan, the lower the interest rate. While the average rate for a 30-year mortgage is right around 6.5%, it's only 6% for a 15-year loan. That will save about $40 a month in interest for every $100,000 that you borrowed.

  • The faster you payoff the principal, the less interest you'll pay over the life of the loan. Instead of spending $127,544 for every $100,000 you borrow, your total interest costs on a 15-year loan would be less than $51,900.

But only do this if you are in the first 10 years of your 30-year loan, or if the 15-year rate is extremely low. Have your lender run some numbers on how much you would save in interest before you decide.

If you can't swing the 15-year payments, check the numbers on a 20-year mortgage.

By Carolyn Siegel Associate Editor

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