Should you refinance, or hang tight?

Don TaylorQuestionDear Dr. Don,
In April 2008, I refinanced my first and second mortgages into a 3/1 adjustable-rate mortgage at 5.125 percent. I intended to move before the mortgage rate adjusted in 2011. With the housing market's collapse, my home's value has decreased dramatically. Moving is out of the question now, as I would get almost nothing out of my home.

I owe $293,000 and the home would appraise somewhere between $315,000 and $335,000. I don't have the 20 percent equity to refinance into a fixed-rate 30-year loan without either incurring private mortgage insurance or using a second mortgage.

Should I hang tight until early 2011 and chance that rates will remain low? Or should I refinance now and incur a second mortgage to take advantage of low rates?
-- Matt Mortgage

AnswerDear Matt,
There's not going to be one right answer, but I'll try to help you figure out the answer that's right for you.

First, estimate what the rate would be on your existing 3/1 ARM if it were to reset today. You need to know the interest rate the lender uses to price the rate and the pricing spread, or margin. For example, if the mortgage lender is using the 10-Year Treasury Constant Maturity as the interest rate plus a 2.5 percent margin, then your loan (if adjusted today) would have a new interest rate of 3.85 percent, plus 2.5 percent -- or 6.35 percent.

An ARM using a short-term interest rate is likely to have less interest rate risk over the coming year than an ARM using a long-term interest rate like the 10-Year Treasury Constant Maturity.

Bankrate's "Rate Watch: Track leading interest rates" provides the current rates on the interest rates used to price adjustable-rate mortgages. Also, review your loan documents to see if any rate caps or floors apply that will limit the interest rate move when the rate adjusts next spring.

Second, consider how long you plan to be in the home. Taking on the closing costs associated with a new first home mortgage to lock in a low rate for the long haul doesn't make sense if you still plan on moving once you see enough appreciation in your home's value to get out of this home and into a new home. Stand pat if you're a short-timer and can afford to accept the interest rate risk of your existing mortgage.

By your estimate, you have between 7 percent and 13 percent equity in your home. Real estate commissions would wipe out half or more of your equity. You could refinance with a new first mortgage and pay private mortgage insurance. Or, try to find an 80-10-10 loan, called a piggyback mortgage, where you take out a second mortgage concurrently with taking out the first home loan to avoid paying PMI. Piggyback mortgages aren't as easy to come by in the post-crisis mortgage market.

PMI paid through 2010 may be tax-deductible, and the government could decide to extend the deductibility into 2011 and beyond. The Bankrate feature "Deducting private mortgage insurance payments" provides more detail about this deduction.

Keep in mind that any price appreciation you see in your house is likely to take place in the next house. If you're planning on trading up, waiting for your house to recover could cost you more money than finding a way to buy the new house now. If you plan on downsizing, waiting for housing prices to recover can work out -- unless everyone in your market wants to downsize and that makes the smaller home's value appreciate more than a larger home.

Waiting until next year to refinance, or sell your home, isn't enough time to get you a whole lot of appreciation in your home's value. There's not a lot of room for improvement in short-term interest rates, and long-term mortgage rates are near historic lows. So hoping for today's mortgage rates to stay at these levels isn't much of a strategy either.

Talk to your current lender about your options, and weigh them against how long you realistically expect to be in the house. Take a look at Bankrate's mortgage loan calculators to help you determine which refinancing option would make sense based on what you know about your home, interest rates and plans for the future.

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To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "Financing a home," "Saving & Investing" or "Money." Read more Dr. Don columns for additional personal finance advice.

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