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Refinancing isn't a no-brainer

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Lower interest rate, less risk are good reasons to refinance
Obtaining a lower interest rate or replacing an ARM with a fixed-rate loan are perhaps the two most compelling reasons to refinance, says Steve Stein, senior vice president of WaMu's Home Loans Group.

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"We are certainly seeing more customers who can refinance into a better rate even for the same kind of product ... (and) for customers who have some kind of an ARM product, this is a great time to move to a product that has less fluctuation in the interest rate over a period of time," Stein says.

Another reason to refinance might be to replace multiple loans, such as a first mortgage and a home equity loan or a home equity line of credit, with just one loan and one monthly payment.

The current downward direction of interest rates might result in lower payments on an existing line of credit without the trouble of refinancing, but fixing the payments on a first and a second mortgage by refinancing into a new first still "may make some sense" for some borrowers, Stein says.

Longer term can erase benefit of lower rate
Regardless of your motivation, you should consider the costs and the term of your new loan before you decide to go ahead, Stein says. While the out-of-pocket costs may be modest, they're typically not zero, and other costs may be added to your loan balance to be paid off as part of your total loan amount.

One way to measure the materiality of those costs is to calculate a payback period by dividing the monthly mortgage-payment savings into the total cost of refinancing. For example, if your new loan reduced your payments by $50 per month and the total cost to refinance was $2,400, the payback period would be 48 months, or four years. Note that this calculation doesn't take into account the fact that you could apply that $2,400 to other financial opportunities if you didn't refinance or that you would have to make more payments if you extended the term of your loan.

Poor reasons for refinancing
The cost is more than the payback period.
Cashing out home equity in return for a higher rate.
Gambling with the perpetual "lower-rate game."

The day when you'll eventually pay off your loan in full may seem like a very long time away, but it's still worth having an "end game" in mind, Stein says. For instance, if you've already paid off seven or eight years of your mortgage, you might want to refinance into a loan with a 15-, 20- or 25-year term instead of a new 30-year term because the additional interest you'd owe over those extra years of payments might negate the benefit of a lower interest rate.

"It makes sense to continue to reduce the term as you refinance so you don't simply go back to a longer amortization term for the purpose of getting a lower payment. That may suit some people, but in general people want to be thinking about what their long-term financial objectives are," Stein said.

The decision to cash out home equity for other purposes is also more difficult today since home values generally haven't appreciated at the same rapid pace that was common a few years ago. Borrowers should "get some smart advice" before they pull equity out of their property, Stein says. It's not smart to refinance your mortgage at a higher interest rate just to pull out a few thousand dollars of equity.

Next: "There will always be a rate that's lower."
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Q&A: Does it make sense to refinance?
Refinance calculator
The basics of refinancing
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