Raring to refinance your mortgage? Reconsider unless you'll actually save

Mortgage rates have been hovering near historic lows for five years. While the current average rate of 4.13 percent for a fixed, 30-year mortgage is not the lowest it’s ever been – that was 3.35 percent in December 2012 – it’s still lower than at any time between 2010 and 1971, when Freddie Mac started keeping records.

Exactly when rates will rise significantly is anybody’s guess, but there’s no question that will happen. This could mean you’ll never see a better time to lower your mortgage rate and your monthly payment by refinancing – but if, and only if, refinancing will save you money.

“We’re still at the lowest rate we’ve been in 30 years,” says Don Frommeyer, president of the National Association of Mortgage Professionals and a mortgage broker in Indianapolis. “Now’s the time to do it. Who knows what’s going to happen in the next 12 to 24 months?”

[Do you want to save money by refinancing? Click to compare interest rates and lenders now.]

But, he adds, to find out if refinancing is the right move for you, you need to consider your goals and crunch some numbers. “If you’re just going to refinance to refinance, that’s not a good idea,” he says.

When weighing whether to refinance, many people rely on a rule of thumb that a reduction of 1 percentage point makes refinancing worthwhile. But that formula ignores important considerations. For one thing, closing costs are vastly more expensive in Florida, for example, than in California, meaning it will take you longer to earn back your refinancing costs.

[Read: The Benefits – and Dangers – of Serial Refinancing.]

Another common formula adds up your closing costs and determines how many months it will take for your payment savings to recoup those costs. For example, if you pay $3,000 in closing costs and save $300 a month, it will take you 10 months to recoup your costs, making refinancing a good deal if you plan to stay in the home more than 10 months.

But those formulas don’t tell the whole story, says Casey Fleming, author of “The Loan Guide: How to Get the Best Possible Mortgage” and a mortgage professional in the San Francisco Bay Area. For one thing, they fail to account for the fact that you’ll be paying on your loan for more years, and you’ll be paying less principal than before.

Fleming advises calculating how much you’d save if you paid the loan back in the same number of years. So, if you had 25 years left on a 30-year mortgage and were refinancing into a new 30-year loan, calculate how much your payment would be if you paid the new loan back in 25 years. Then divide that number into your closing costs and see how many months it will take to recoup your costs.

Fleming also suggests estimating how long you’re going to keep the property. Then you can get an idea of what the principal balance will be when you’re ready to sell and compare that with what the balance will be if you don’t refinance.

[Think you’ll save money by refinancing? Click to compare interest rates and lenders now.]

“It drives me crazy when people overpay,” he says. “People end up paying more money to the bank because they refinanced,” not realizing that the interest rate wasn’t the only important number.

Many lenders will offer to refinance your loan with no closing costs. That merely means you don’t pay the costs upfront, but they are rolled into the cost of the loan, either as a higher mortgage rate or an addition to the principal.

If you’ve done the math and refinancing looks like a good deal, the next step is getting estimates from several lenders or brokers. You’ll need good credit to get the best rates, and you’ll need to be able to document your income. If you’re self-employed or work on contract, lenders will want to see contracts and also a track record of two years of self-employment income high enough to repay the loan. Sometimes meeting income requirements is challenging for those who write off a lot of expenses because lenders consider the net, not the gross, income if you’re self-employed. Everyone, self-employed or not, should expect more paperwork.

“You will have to provide significantly more documentation, and there will be a lot more questions about your documentation,” Fleming says.

[See: 12 Simple Ways to Raise Your Credit Score.]

The house will also have to pass muster. The Federal Housing Administration is especially picky about issues such as chipped paint and ceiling cracks. Appraisers are asking for termite inspections, foundation inspections and other reports to document the condition of the house, Fleming says.

If you’re not taking cash out, you can refinance to 90 to 95 percent of your home’s value on a conventional mortgage, 97 percent on an FHA loan and 10 percent on a Veterans Affairs loan, although you will have to secure private mortgage insurance or its equivalent if your loan is for more than 80 percent of your home’s value.

If you want to take out cash, the limit is 75 to 80 percent on a conventional loan and 85 percent for FHA. And, Fleming says, you’ll pay a higher interest rate.

The Home Affordable Refinance Program even allows people who are underwater on their mortgages but current on payments to refinance to take advantage of lower interest rates. HARP loans have to be backed by Fannie Mae or Freddie Mac, but those entities back most loans.

Remember that just because you can refinance doesn’t mean you should. Here are some things to consider:

How long are you going to be in your home? The longer you plan to stay, the more advantageous it is for you to cut your monthly payment.

Do you want a longer mortgage? If you’re 10 years into a 30-year mortgage and you refinance, you’ve now got 30 more years to pay. Are the monthly savings worth 10 more years of payments?

Do you want a shorter mortgage? Homeowners nearing retirement age may want to refinance into a shorter mortgage, especially if they can get a better interest rate. In recent years, 15-year, 20-year and even 10-year mortgages have grown in popularity. The shorter the mortgage, the less interest you pay.

[Do you want to refinance your mortgage? Click to compare interest rates and lenders now.]

What are your closing costs? Make sure you take all costs into consideration, including title fees, local taxes, lawyer’s fees and loan-related fees.

[Read: 5 Alternatives to the 30-Year Mortgage.]

Should you pay points to get a lower rate? “In most cases, it makes a lot of sense to pay money to bring down the interest rate,” Fleming says. Paying three points, for example, could lower your interest rate from 4.25 percent to 3.5 percent. (Points are fees. One point is equal to 1 percent of the loan amount, so one point on a $200,000 loan would be $2,000.) Over years, that could shave way more than you paid in points off your balance. “It’s a huge difference, much, much larger than you would think,” Fleming says.

Is taking cash out for home improvements a good idea? If you take out $20,000 in cash on your 30-year mortgage to remodel your kitchen, you’re actually paying for that kitchen for 30 years. You may have to make some of those improvements two or three more times before you’re finished paying off the first round. “You’re financing a paint job for 30 years,” Fleming says.

Should you refinance to pay off debt? Be careful. “Debt consolidation almost never makes sense in the long run,” Fleming writes in his book. “It almost always works out to be a very long-term, expensive solution to a short-term problem.” If you don’t make your credit card payments, you won’t lose your house. If you roll that debt into your mortgage and you don’t make the payments, you can lose your house.

Would a home equity line of credit be better? Possibly, if your needs are short-term. The current interest rate is prime plus 1, or 4.25 percent, about the same rate as a 30-year mortgage. However, equity lines have variable interest rates. Historically, prime has been much higher, so your rate could rise substantially in the future.

Do you have an FHA loan? You may be eligible for a streamline refinance, which doesn’t require verifying income or assets or doing an appraisal.

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