Five costly errors you'll want to avoid when refinancing

Are you thinking of refinancing your mortgage? Here are five things you don't want to do.

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Refinancing could save you a lot of money. That is, if it's done right and under the best circumstances.

But do it wrong and it could cost you - a lot.

"Every person's situation is different, so it's a case-by-case question of whether refinancing makes sense. It doesn't make sense for everyone, and people should know the potential costs going in," says Jim Duffy, a mortgage banker with Cole Taylor Mortgage.

For that reason, we thought we'd look into the most common blunders people make when refinancing - and how much each mistake could cost you. Read on to see what blunders you should avoid...

Blunder #1: Not Shopping Around

Shopping is your right. Shopping is American. Shopping is just plain smart. And when refinancing, you should always shop around.

"While there's not a lot of difference in rates right now, that doesn't mean you shouldn't shop around," says Chris Boulter, president of Val-Chris Investments, Inc., a California-based company specializing in residential and commercial loans.

He says one thing that could vary from lender to lender is the mortgage terms, such as closing costs and fees. These can make a difference in the up-front cost of refinancing your loan. For instance, on a $300,000 mortgage, just a quarter of a percent difference in the up-front costs means a difference of $750.

But of course, the biggest contributor to your mortgage costs is the interest rate you pay over the life of the loan. For that reason, says Boulter, it's vital you get the lowest rate you qualify for. In fact, even a quarter of a percent difference between lenders can really add up.

Don't believe us? Let's check the math. Below is a comparison between two $300,000 mortgages. Both are 30-year fixed-rate loans, but Loan A has a 3.5 percent interest rate*, and Loan B has a 3.75 percent interest rate (a quarter of a percent higher).


  A: Mortgage at 3.5 Percent B: Mortgage at 3.75 Percent
Loan Amount: $300,000 $300,000
Interest Rate: 3.5 percent 3.75 percent
Monthly Payment: $1,347.13 $1,389.35
Total Interest Paid: $184,968.26 $200,164.84

The Lesson: Shop till you drop! Or at least collapse in a state of money-saving grace. Why? Because negotiating a quarter percent drop in interest rates could result in more than $15,000 in savings over the life of your loan. And you'll be reminded of that monthly with a $42 lower payment.

[Want to lower your mortgage costs? Click to shop around compare rates from multiple lenders now.]

Blunder #2: Ignoring Closing Costs and Fees

If you thought those nice lenders would refinance your loan for free, well, think again. Refinancing is a service, and you've probably noticed banks (lenders) generally like to charge money for services.

And when it comes to closing costs and fees, ignore them at your own peril. That's because closing costs and fees could outweigh any refinancing savings. To see why, let's take a closer look at some specifics.

In general, closing costs add up to about 1 percent to 1.5 percent of your loan amount, says Jim Duffy. On a $300,000 loan, that's $3,000 to $4,500.

And in case you're wondering, closing costs and fees typically include things like loan origination fees, application fees, appraisal fees, and other charges, according to a refinancing guide published by the Federal Reserve System, which oversees national monetary policy and the banks.

The Lesson: Make sure refinancing your mortgage is worth the cost. Duffy says a rule of thumb is that if you can lower your interest rate by enough to pay for the closing costs and fees within 18 months, it's generally a good idea to pursue refinancing.

Blunder #3: Over-looking Shorter Term Mortgages

Mortgages last for 30 years, right? Right. Unless it's a 15-year mortgage. Yep, it turns out you have a choice, and choosing wisely could either save you a lot of money or lose you a lot of sleep.

"Typically, you'll get a slightly lower rate on a 15-year mortgage than a 30-year one," says Duffy. "But the real savings come in the amount of interest you pay over the life of the loan." He explains that because you're paying off your loan in half the time, you could save tens or even hundreds of thousands of dollars, depending on the amount of the loan.

However, there is one thing you need to understand: Even with the lower interest rate on the 15-year mortgage, your monthly payment will be higher. This is because you're paying off the loan in half the time and the principal (the amount you originally borrowed) remains the same, says Duffy. So it takes bigger payments to pay it off sooner.

But enough with the talk; let's move on to another example of why you shouldn't overlook shorter-term mortgages. For this one, we'll compare two mortgages of $300,000. The first will be a 30-year, fixed-rate loan with an interest rate of 3.5 percent*; the second will be a 15-year, fixed-rate loan at 2.75 percent*.


  30-Year Mortgage 15-Year Mortgage
Loan Amount: $300,000 $300,000
Interest Rate: 3.5 percent* 2.75 percent*
Monthly Payment: $1,347.13 $2,035.86
Total Interest Paid: $184,968.26 $66,455.68
Total of All Payments: $484,968.26 $366,455.68

The Lesson: If you can handle the higher monthly payment, consider a shorter-term mortgage. You could save a lot in interest and own your home outright in half the time. That's about as far from a blunder as you can get.

Blunder #4: Not Getting a Fixed-Rate Mortgage

Have you been teased by those adjustable-rate mortgage rates that dip below 3 percent? While they are very attractive, it's good to note that they're likely to adjust upward when they do change, says Duffy.

But before we get to that, let's nail down exactly how an adjustable-rate mortgage (ARM) differs from a fixed-rate mortgage. For that, we'll turn to the Federal Reserve's handbook on adjustable-rate mortgages.

"An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways," notes the Federal Reserve. "Most importantly, with a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly."

The most common ARM stays fixed for five years, then adjusts every year or even six months, says Duffy.

Duffy and Boulter both recommend against ARMs except in very specific cases, such as a borrower being dead certain they will be selling their home within a few years. Otherwise, says Duffy, they're missing out on locking in a historically low interest rate and getting long-term savings, and instead, enjoying only short-lived gains.

"My recommendation is to remind [homeowners] that while that 2 percent rate is attractive now, it will adjust in year 6 and it's probably going to go up, because with rates this low, there's not much room for it to go down," says Duffy.

The Lesson: While no one knows what the future holds, with interest rates so low currently, Duffy says that getting an ARM and giving up the security of a fixed-rate mortgage makes little sense.

Blunder #5: Not Knowing Your Home's Value

Do you know what your home is worth? It's an important question if you're thinking of refinancing your mortgage. Why? Because it could affect many things, from whether you qualify for refinancing to the rate you pay, or if you have to pay private mortgage insurance (PMI), says Duffy.

The best case scenario, he says, is that your home is worth at least 20 percent more than the mortgage amount. In other words, you are trying to refinance only 80 percent or less of your home's current market value (and yes, the lender will want a professional appraisal).

What if your situation isn't the best case scenario? Don't fret. With other qualifications such as good credit and a stable job history, you still have hope - though you may not be able to get the lowest rates.

What's more, if you don't have 20 percent equity, you'll likely also have to pay private mortgage insurance (PMI), which is often required by lenders to insure them against you falling behind on your loan payments, according to the Federal Reserve.

In case you're wondering, Duffy says PMI costs range depending on the amount of equity you have, the amount of the loan, your credit score, and possible other factors. As an example, he says, for a $300,000 loan, it could range from $50 to $200 per month.

The Lesson: Before you start down the paper trail of refinancing, have a sober assessment of how much your home is worth. If you have less than 20 percent equity, make sure you can reduce your mortgage interest rate by enough to make up for the added cost of PMI.

*The November 8, 2012 average for 30-year fixed-rate mortgage was 3.4 percent and 2.69 percent for a 15-year, fixed-rate mortgage, and 2.73 percent for a 5/1 ARM, according to Freddie Mac, an institution established by Congress in 1970 to provide liquidity, stability and affordability to the nation's residential mortgage markets.

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