Refinancing Your Home

The best time to refinance depends on many things, including the interest rate difference between your existing mortgage rate and the new mortgage interest rate, closing fees for refinancing, how long you plan to stay in your home, your tax bracket, your lender, and even your local housing market.

You may be a refinancing candidate if you are paying at least 2 percentage points above the present interest rate. For example, a $60,000 mortgage at 12 percent interest for 30 years results in a principle and interest payment of $617.16. By refinancing the same mortgage at a 10 percent rate, your payment would be $526.56, a $90.60 savings per month. Property taxes and insurance cost will remain constant even with a lower interest rate.

Since there are settlement or closing costs for refinancing, it is a must you consider the 2-percentage-point spread as the minimum. This spread enables you to recover the closing costs through savings and interest payments within 2 or 3 years normally. If you plan to live in a house longer, you may consider refinancing with a difference smaller than 2 percent. On the other hand, if you have to pay mortgage "prepayment penalties," you might decide to wait for a larger difference than 2 percentage points.

Closing Costs

Since most lenders handle refinancing as a new mortgage, settlement or closing costs are incurred. These are likely to include a loan origination fee (approximately 1 percent of the loan amount), discount points (usually 0 to 5 percent of the loan amount), application fee between 0 and $250, an appraisal fee from $100 to $350, title examination approximately $250, title insurance (for the lender) approximately $3.50 per $1,000 of the loan, a land survey about $150, credit report around $50, document preparation fees about $10, and legal fees (including notary and recording fees) of $250-plus.

Special attention should be given points that are an up-front fee collected by the lender, with each point equaling 1 percent of the loan amount. Charging points is a technique lenders use to adjust interest rates. The lower the interest rate the more points you normally pay.

Many lenders routinely offer two or more choices of point-interest rate combinations. For example, you may be offered a choice between an interest rate with 2 points or a half a percent higher with no points. Each point you pay will probably lower the interest rate by the overall value of the loan between 1/8 or 1/4 to 1 percent.

If you decide to refinance a $55,000 mortgage at 9.5 percent with 2 points, be prepared to pay $1,100 in points costs.

Consider any prepayment penalty applied to your existing mortgage. Prepayment penalty is an extra or additional percentage of the balance you must pay if you pay off the loan early. Generally, prepayment penalties apply only to the first 5 years of the loan life. The penalty may start at 5 percent of the loan if you pay it off in the first year, 4 percent for total payment the second year, and so on until after the fifth year when no penalty normally applies.

Calculate your breakeven period-the time it takes to recover the closing costs and begin to save money from the lower payments. To do this, you must secure from the lender the amount of the closing costs, an amount of the monthly payment for a mortgage you are considering, and the amount of the prepayment penalties (if any) for your existing mortgage. Divide the total cost (including the closing costs, points, and prepayment penalty) by the reduction in your monthly payments if you refinance. For example, if refinancing a mortgage requires $2,500 in closing and prepayment costs, but you would save $180 per month in mortgage payments, the breakeven period is about 14 months ($2,500 divided by $180).

Tax Considerations and Refinancing

There are three tax considerations. First, paying a lower interest rate on your mortgage means you will have less interest to deduct on your income tax return. That, of course, will increase your tax payments and decrease the total savings from a new lower interest mortgage. The lower your tax bracket, the longer it may take you to recoup the cost of refinancing.

The second consideration is that points and the loan origination fee (if for general processing costs only, not specific costs such as a title search) usually are tax deductible. The Internal Revenue Service requires that points (interest) paid in advance for refinancing cannot be deducted all at once in the year you refinance. They must be spread over the life of the mortgage. The IRS allows you to deduct the points immediately if the proceeds of refinancing are used to pay for the substantial refurbishment of your home. Be sure to check with the IRS to see if any new rulings have been released. Additional regulations concerning refinancing may be issued.

The third consideration is the 1986 Tax Reform Act has important implications for refinancing decisions: mortgage, interest, and points remain deductible but you may be in a lower tax bracket. This could make shorter-term mortgages such as the 15-year mortgage more desirable, especially to homeowners who were in tax brackets of 33 percent or above.

Often in the refinancing process, individuals decide to borrow equity from their home. The amount able to be withdrawn usually depends on the appraised value of the home and the loan-value ratio you choose. Normally, an individual can refinance up to 80 percent of the current value of the home. This is sometimes done when the lender offers to finance part or all of the closing costs so you do not have to pay for these costs up front. This means the points will be added to the loan balance. Although this may sound good and enable you to refinance with little or no out-of-pocket expenses, you will be paying interest on those costs for the life of the loan.

If you decide to refinance for more than the original loan amount and your home has appreciated in value, check the tax code carefully. Generally, you can take the full interest deduction only if the amount of the new mortgage is equal to or below the original price you paid for the house, plus the amount you have spent on "home improvements" and the amount, if any, you have borrowed against your house. For example, if your original home cost $60,000, you added $10,000 of home improvement cost, $4,000 educational expenses, and $1,000 medical expenses, then $75,000 is the maximum mortgage amount with fully deductible interest.

Types of Mortgages

Since a 15-year mortgage is amortized over a short period of time, equity builds quicker with less interest expenses. A biweekly mortgage payment decreases the length of a 30-year loan by approximately 11 years, thereby saving interest expenses.

A fixed-rate mortgage helps reduce risk of future interest rate and payment increases. Adjustable-rate mortgages have variable interest rates based on several economic predictors. Some adjustable-rate mortgages permit you to transfer to a fixed-rate mortgage, usually during the first five years of the loan.

Shopping for a Home Mortgage

If you decide to refinance your mortgage, call several lending institutions for the interest rates and fees they charge. Ask for the "annual percentage rate" (APR) and compare them. Remember, you do not have to refinance your mortgage with the same lender who provided your original mortgage. However, to keep your business, some lenders will offer original mortgage customers the incentive of lower mortgage interest rates, sometimes with reduced closing costs.

If you decide to apply for refinancing with a particular lender, it is necessary to obtain a written statement guaranteeing the interest rate and the number of discount points you will pay at closing. This statement insures the lender will not raise the costs even if rates increase before you close on the new loan. If your lender will not put this information in writing, you may wish to choose one who will.

Most lenders place a limit on the length of time (approximately 60 days) they guarantee the interest rate. You must sign the loan during that period of time or lose the benefit of that particular rate.

Questions To Ask When Shopping for a Mortgage

1. What types of mortgages are offered (30-year, 15-year, ARM, etc.)?
2. What interest rate and discount point options are offered?
3. What is the APR for each mortgage?
4. What are the terms of the mortgage (loan-value ratio, prepayment penalties, rate caps, index, and margin of ARM's, etc.)?
5. What closing costs are required when refinancing?
6. How much will it cost to refinance the mortgage?
7. Is there an application fee, and is it refundable?
8. Can the interest rate be locked in? For how long? Is there a charge?
9. What is the cost of mortgage insurance, and when is it paid?
10. Could the survey and title charges be reduced by using the same companies who secured them for your present mortgage?

By Dr. Frances Graham, Extension Housing Specialist

Mississippi State University does not discriminate on the basis of race, color, religion, national origin, sex, age, disability, or veteran status.

Information Sheet 1391
Extension Service of Mississippi State University, cooperating with U.S. Department of Agriculture. Published in furtherance of Acts of Congress, May 8 and June 30, 1914. Ronald A. Brown, Director

Copyright by Mississippi State University. All rights reserved.

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