Refinancing: The Right Move?

Unless you've been cast away on an island, à la Tom Hanks with a FedEx box or two, you know that our very own Fed in Washington has been slashing interest rates. In June, 2003, it cut fund rates (the rate banks charge each other for overnight loans) from 1.25 percent to 1 percent—a 45-year low.

This makes refinancing tempting, especially if you bought your home when rates were much higher. But refinancing isn't for everyone: It's not a one-size-fits-all situation, nor is it a free process.

The word "refinancing" itself is somewhat confusing. It implies that you will simply be fussing around with and ultimately changing your current mortgage. Not true. When you refinance, you actually pay off your old mortgage and then replace it with a new one.

Refinancing also involves many of the same expenses incurred when you took out your original mortgage. The only difference: This time you don't have to move.

Caution: If your current mortgage contains a prepayment penalty, refinancing may not be viable—the penalty could offset any savings you would gain.

Why refinance?

Key reasons to consider refinancing:

A lower rate. You want to get out of a high-interest-rate loan and take advantage of lower rates.

A fixed rate. You have an adjustable-rate mortgage (ARM) and you want a fixed-rate loan so you'll know exactly what your payments will be for the life of the loan.

Better terms. You have an ARM but want one that has a better rate and more favorable payment caps.

Equity build-up. You want to increase the equity in your home more rapidly by converting to a shorter term loan.

Perhaps you're making more money now and can handle a 15-year instead of a 30-year mortgage. Although the monthly payments will be higher, over the long term your interest costs will be much lower—a wise move to make as you near retirement so you can be mortgage-free when you stop working.
Access to cash. If you've substantially reduced the outstanding principal on your loan, you could trade in your old mortgage for a new one with a larger balance. Then, you can use the cash to pay off a higher interest rate debt, fix up your house, pay for college, start a business and so on. It's called cash-out refinancing.

Caution: If you go for cash-out refinancing, you may jeopardize what is probably your most important asset. So, if you've paid off most of your mortgage and you need cash for a specific purpose, a home equity line of credit may be financially smarter. Find out more about home-equity loans.

Should you refinance or not?

Yes—if you will save enough from lower monthly mortgage payments to offset the costs of getting a new mortgage.

The two percent solution

The famous "rule of thumb," that you should refinance if your new rate is two or more percentage points less than your existing mortgage, is just that—a rule of thumb. Don't be misled by such simplistic thinking. Whether or not refinancing makes sense depends on how long you plan to stay in your house, how much you have left on your current mortgage, the terms of a new mortgage and the total closing costs. In general, the longer you plan to live in your home, the better because it gives you time to recoup refinancing costs and start to save money.

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