When Should You Refinance?

When 32-year-old James W. Johnson of Raleigh, North Carolina, bought his first home five years ago, the best deal he could find was an adjustable rate mortgage with a 5.625% interest rate. Last April, aware that his ARM was about to reset, Johnson refinanced to a fixed-rate mortgage with a 5.275% interest rate. “I was blessed enough that interest rates have gotten lower in the last five years,” he says.

With the nation recovering from a deep recession, many homeowners are facing cash flow troubles, crippling debt, and mortgages that they can no longer afford. Under the right circumstances, refinancing–that is, paying off an existing mortgage with a new one–can lower monthly expenses and save money. But when it’s not thought through, refinancing can erode a homeowner’s wealth through lost equity, closing costs, and additional interest payments.

According to the Mortgage Bankers Association, the number of refinance applications was 30.82% higher in early December 2008 than it was a year earlier, at the start of the recession (though the pace has actually declined since). But a new loan isn’t always a better loan, says Marc Savitt, former president of the McLean, Virginia-based National Association of Mortgage Brokers. Here are some scenarios in which refinancing might help your bottom line:

You don’t have a fixed-rate mortgage. If your loan is an ARM or interest-only loan that will soon reset to a higher rate, now is the time to get out of it. As of press time, interest rates on a 30-year fixed-rate mortgage averaged 5.06%, according to Bankrate.com. But low interest rates are no reason to stay with an ARM. “How much lower are they going to go?” says Savitt. “And even if they do go a little lower, is it worth taking the risk that if you wait they could go higher?”

You have too much consumer debt.  If you’re saddled with credit card debt, refinancing could enable you to use equity from your home to pay

it off by rolling it into your mortgage. The mortgage would likely have a lower interest rate, plus mortgage debt is tax-deductible. Proceed with caution, though, because you could pay more in the long run since you’re spreading the credit card payments out for 30 years. But according to Kirk Charles, author of How to Get a Mortgage During & After the Subprime Crisis (CreateSpace; $16.95) and a blogger at BlackEnterprise.com, it’s a viable option for cash-strapped homeowners because it can lower monthly expenses. “In today’s economic times, when people are losing jobs, cash flow is king,” he adds.

You want to pay off your mortgage faster. Decreasing their monthly mortgage payment isn’t the only reason homeowners refinance. In fact, taking on a larger mortgage payment and refinancing it into a shorter-term loan, such as a 15- or 20-year mortgage, isn’t a bad idea. Not only will you build equity faster, but “you can possibly get a lower interest rate with a shorter term, and you’ll pay less interest in the long run,” Charles points out.   Thinking of Refinancing? Not So Fast …

In these situations think twice before refinancing:

The savings don’t  outweigh the costs.
Take closing costs into consideration when deciding whether or not to refinance. Costs associated with closing can be anywhere from 3% to 6% of your outstanding principal depending on the state you live in and which lender you choose.

You’ve consolidated debt more than once.
“Refinancing should not be used as a regular practice for reducing debt,” says Alexandria R. Cummings, a Chicago-based senior financial adviser with Polaris Wealth Management. Instead, adjust your budget so you can live within your means.

You’re planning to move in a couple of years.
“The shorter the length of time that you plan to keep the mortgage, the less sense it makes to refinance because unless you pay the closing costs out-of-pocket you’ll be pulling equity out of the house,” advises Kirk Charles, author and blogger at BlackEnterprise.com. When your motivation for refinancing is to lower your interest rate, you’ll realize the greatest savings over time.

The interest rate is still too high.
The rule of thumb for considering a refinance is to wait until interest rates are two percentage points lower than the one you currently have, Cummings says. Otherwise, the closing costs might cancel out any savings in interest you would have gained. To estimate your savings use a refinance calculator such as the one at Calculators4Mortgages.com.

You’ll incur a prepayment penalty.
Some mortgage contracts specify that a penalty will be charged if the loan is paid off early. Add this cost to other closing fees to see if you would still save money over time. But first ask the lender to waive or reduce the fee. There are no guarantees, but as Marc Savitt, former president of the National Association of Mortgage Brokers observes, “everything’s subject to negotiation.”

This article originally appeared in the February 2010 issue of Black Enterprise magazine.