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| Refinancing |
Any time mortgage interest rates drop, homeowners flock to refinance
their loans. The question is, should they? Refinancing is not always
beneficial. In some instances, there is more to be gained by banking
the money required for refinancing charges and fees. And timing can
be key. If rates have not hit bottom, borrowers may save more by waiting
for even lower rates.
Refinancing lowers the monthly payment, but getting the new loan usually
involves some cost. Borrowers hope monthly savings will eventually
total more than the cost to refinance.
A borrower refinancing a mortgage loan has three options: Get a new
loan and pay all the fees and points in cash. Get a new loan and finance
the costs into the loan. Get a "no cost" loan that charges
no fees or points.
Previous rules of thumb used to determine whether refinancing is worthwhile
are mostly obsolete. Tables 1, 2 and 3 serve the same purpose but
are based on specific loan characteristics and financial calculations.
Loans with cash costs should offer sufficient savings to provide a
competitive return on the cost of refinancing. Otherwise, the borrower
is better off keeping the existing loan and putting the money it would
cost to refinance in an interest-bearing account.
Table 1 can be used to determine the maximum interest rate on the
new loan that provides a good return over the time the loan is outstanding.
A borrower should refinance only if the new loan rate is no higher
than the rate in the table. The lower interest rate on the new loan
reduces the monthly payment and allows the loan to amortize faster.
The information in this table is based on the following assumptions:
- the amount of the new loan equals the balance of the old loan
(no cash out),
- there is no prepayment penalty,
- all costs are paid in cash at closing,
- maturity of both loans is 30 years and
- the borrower can get a return of 2 percentage points below the
refinanced interest rate on alternative, safe investments.
To use the table, first determine how long the borrower expects to
hold the new loan. The table has sections for three-, six- and ten-year
holding periods (pick the one that most closely matches the time horizon).
The longer the new loan, the more savings will accumulate.
Second, estimate the cost of refinancing as a percentage of the loan
amount. The table shows costs from 1 to 5 percent of the loan. Find
the interest rate on the existing loan in the left-hand column. The
intersection of the cost column and the row showing the old rate indicates
the maximum interest rate the new loan could carry for refinancing
to be worthwhile.
For example, if a borrower expects to live in the home for another
six years, the current mortgage is 9 percent and it costs 3 percent
to refinance, the new loan must have an interest rate of no more than
8.375 percent.
Table 2 functions identically but is for cases in which costs are
fully financed into the new loan. Assumptions are the same as for
Table 1, except that the new loan is for an amount equal to the old
loan balance plus closing costs.
No-cost loans mean no out-of-pocket expense to the borrower. The lender
pays the cost of refinancing. Because these loans require no cash
investment, refinancing is worthwhile if it reduces the interest rate
on the loan. However, borrowers should consider whether they could
get an even lower interest rate by paying closing costs. Which type
of loan provides the better deal?
Table 3 answers this question. Find the row that comes closest to
the interest rate offered on the no-cost loan. Then go to the column
representing the percentage cost of refinancing for loans requiring
payment of closing costs. If the interest rate offered on the loan
with closing costs is lower than the rate indicated at the intersection,
then that loan is a better deal than the no-cost loan.
For example: assume a no-cost loan is available at 7 percent interest
and the going rate for loans with 2 percent costs is 6.5 percent.
Also assume the borrower expects to live in the house for at least
ten years. The intersection of the 7 percent row and the 2 percent
column is 6.625 percent. The loan with 2 percent closing costs is
a better deal because the interest rate offered, 6.5 percent, is lower
than 6.625 percent.
Dr. Harris (jharris@cgsb.tamu.edu)
is a research economist with the Real Estate Center at Texas A&M
University.
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Equal Housing Opportunity 
