Question: I have a 6.5 percent mortgage on my home. I recently was approached by a lender, who has offered to refinance my loan with an interest rate of 5.75%. I owe $105,000, and my existing loan will be paid off in about 10 years.

This mortgage lender has advised me that the only cost to me will be $500 for a processing fee. Should I refinance my existing loan?

Answer: This has become a recurrent question -- and problem -- in the past few years. Interest rates are very low. Many people actually have been refinancing once a year, just to take advantage of low rates and lower monthly payments.

And to further complicate things, more and more lenders are using the internet as a marketing tool to promote their loans. Most of these Web-based lenders are legitimate, but some are not. And you may not know the truth about these lenders until it is too late.

It used to be a rule of thumb that if interest rates were at least two percent lower than your current mortgage, it would be time to refinance. However, this rule is only a theory; each homeowner must carefully analyze their specific situation by taking out a pencil, paper and calculator and "doing the numbers."

Let's take your example. Your mortgage rate is 6.5 percent, and your current balance is $105,000. Your monthly mortgage payment (not including any escrow for taxes and insurance) is now $1200.93. If you refinance this same amount for 5.75 percent, your new monthly payment will be reduced down to $612.75 -- a monthly savings of $588.18. That's over $7000 a year that you can save.

But are you really saving? Why the dramatic drop in the monthly payment?

That is because your original loan was $190,000, and you have been paying it off -- ever so slowly -- over the past 20 years. Your new loan will start all over, and if you keep that loan for the full 30 years, you will have to pay over $115,600 in interest payments alone.

Now, you have to make a major decision: refinance or not? Clearly, there will be a substantial savings if you go for the new loan. But are you prepared to continue to make mortgage payments for the next 30 years? Are you willing to throw out over $115,000 in mortgage interest alone?

There is, of course, a compromise. Assuming that there will be no prepayment penalty should you decide to make larger monthly payments, then you can take advantage of the new rate, while at the same time paying off more toward principle.

Let me explain: Say you refinance, but instead of paying $675 a month you continue to make the same payment you were making with the old loan. Each and every month, your principle will be reduced by this extra $588 payment. Clearly, your new 30-year loan will be paid off much faster, and you will end up paying a lot less interest.

Do the math: Your first payment will be $1200. Interest for the first month will be $503.13 (($105,000 x 5.75%) / 12). The rest of your payment (namely $696.87) will lower the balance down to $104,303.13. The monthly interest on this amount is $499.79. Once again, the difference between the required interest and your $1200 monthly payment (namely $700.21) will reduce your loan balance down to $103,602.92 when you make your second mortgage payment. And so on until your loan has been paid off.

This calculation is easy with a calculator, and even easier if you have access to an amortization program on your computer.

But the bottom line is that you will "get more bang for your buck" because you will be making the same mortgage payments but more will be going to principle. And if you pay income tax, and are eligible for mortgage interest deductions, you will find that you'll have more deductions when you refinance.

But, you must shop around and compare rates -- and closing costs -- with other lenders. The loan you are considering may be great, but then again, it may not be. Unless you talk with other lenders you will never know.

You should also understand that when you refinance your current mortgage, you will probably have to attend a brand new settlement. Your refinance lender has to start from scratch. The lender must obtain current financial information about you, obtain a new appraisal of the property, and receive an updated title report. Just because everything was acceptable several years ago when you obtained your first mortgage does not mean that everything is acceptable today. The refinance lender does not know the value of your house, and clearly will not lend you more than the house is worth. The new lender also does not know whether there are any judgments or liens against you which will impact on your title.

The only real difference between a purchase and a refinance is that there is no buyer or seller present at closing, and there will be no real estate broker involved.

The broker who contacted you has indicated that you will only have to pay $500.00 for a processing fee. Do you have this in writing? When do you have to pay it -- now, when you apply, or when you go to closing?

Talk to other lenders first. Make a chart of all of the expenses. Determine if your lender will charge you any up-front points. A point is one percent of the loan amount, and if you were to borrow $105,000, each point you pay will cost you $1,050. Each point is the equivalent of approximately 1/8 of an interest rate. Thus, you may find a lender who will be offering a slightly lower rate if you pay one point.

It is strongly recommended that if you are working with an internet lender, you should not make any upfront payments. There are too many scams in today's world. You can protect yourself by either obtaining a loan in the amount of $500 more -- so that the lender will take its fee out of your refinance loan proceeds -- or arrange to make that payment when you go to settlement.

If you currently have an adjustable-rate mortgage, you will probably be thinking that the rates will be going down this year, and thus why should you bother refinancing?

This is a major dilemma, and you are probably correct. If your existing loan is more than one year old the rates may very well go down at the next adjustment period.

But, there is no guarantee what the future may bring. Economists are already predicting that interest rates will probably start inching up slowly. Our economy appears to be recovering, but very slowly. The Federal Reserve Board has already dramatically lowered the bank interest rates to an all-time low, and it is not clear how much lower they can go -- or will want to go. If and when mortgage rates increase, then your adjustable will follow on the upward path.

In my opinion, there is considerable merit in locking in a fixed 30-year mortgage at a lower interest rate; peace of mind is important in planning your financial future.

Finally, you should also contact your current mortgage lender. Some lenders provide a refinance program which does not involve a lot of up front closing costs. Basically, your current lender should not need a new title search or a new survey; all they have to do is record a modification of your existing mortgage documents among the land records in the jurisdiction where your house is located.

It's your money, and it's your home. To properly protect both, you must do your homework.

Published: November 10, 2003

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