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Ask Dr. Don
Bankrate.com

Timing a refinancing

Dear Dr. Don,
We have 20 years and nine months left to pay on our 7.5 percent mortgage. The balance is $109,840.41 and our principal and interest payment is $877.86 a month. We're considering refinancing to lower the monthly payments with the goal of keeping this house as a rental when we move in a few years.

We can lower the payment by about $200 a month if we refinance, but we'll pay more interest in the long-run. Is refinancing a good idea for us? (We're in the 15 percent tax bracket.)
Trina Tenants

Dear Trina,
Your big decision isn't about when to refinance, it's about how you will use the equity in your current home to fund the down payment on your new home. Will you use a cash-out refinancing or a home equity loan? When the current home becomes a rental property you will want a high loan-to-value on the property to offset the rental income.

Owner-occupied financing is different from financing for income (rental) properties. You need to determine whether the then-existing financing can survive the conversion of your principal residence to income property. In most cases, you can keep the existing loan. You will also need to convert your homeowners policy to a landlord policy.

Don't forget to consider the tax consequences of conversion. If the home no longer qualifies as your primary residence, you won't be able to take advantage of the capital-gain exclusion on a primary residence.

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On the other hand, rental property can generate deductions that a primary residence cannot and may be used in a tax-free exchange for other properties down the road. Meet with your tax professional to fully understand these issues before converting the property to rental. The goal is to have no surprises when you file your income taxes.

Spend the time to put together a business plan for the rental property. It'll help crystallize what you can expect to earn in returns on the investment and define the cash needs associated with the project.

Regardless of your intent to convert your personal residence to rental property within the next few years, you should base the decision to refinance on your current situation. Can you recoup your closing costs in a reasonable payback period? The table below uses current market rates to estimate the payment and interest expense on a new mortgage.

 

Existing mortgage

New 30-year fixed rate

New 15-year fixed rate

Loan balance:

 $109,840

 $109,840

 $109,840

Loan term (months):

249

360

180

Interest rate:

7.60%*

6.09%

5.51%

Payment:

 $877.93

 $664.92

 $898.07

Total payments:

 $218,606

 $239,370

 $161,652

Total interest:

 $108,766

 $129,530

 $51,812

Interest savings (expense):

 

 ($20,764)

 $56,953

* Interest rate needed to make monthly payment approximate Trina’s payment information.

As you point out, total interest expense will increase with a new 30-year mortgage despite the lower interest rate because of the longer loan term. You shouldn't just consider the interest expense; you also have to consider what you can do with the difference in monthly payments.

The 15-year mortgage is a good example of this reasoning. For a monthly payment of just $21 more than your existing payment, you can pay off your home in 15 years and save $56,953 in interest expense.

Rather than looking at the mortgage alternatives over the life of the loan, let's just look at the next three years. The table below shows that refinancing can save you $4,500 to $7,300 in interest expense. Weigh that against your closing costs and you should see that you're past breaking even on the refinancing.

For the 30-year loan you can use Bankrate's refinancing calculator to determine how many months it will take you to recoup your closing costs.

 

Existing mortgage

New 30-year fixed rate

New 15-year fixed rate

Interest expense next 3 years:

 $24,261

 $19,704

 $16,956

Interest savings:

 

 $4,558

 $7,305

-- Posted: Dec. 24, 2002

Read more Dr. Don columns
See Also
How to refinance your mortgage
When not to refinance
Financial advice glossary
More Dr. Don stories

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