refinance

There's more to refinancing than low rates

Don TaylorQuestionDear Dr. Don,
Is there a way for me and my wife to refinance our home and benefit from the all-time low mortgage rates without extending the length of our payments? We obtained a 15-year fixed-rate mortgage in August 2003 for $132,000 and 4.75 percent. Our monthly payments have always included an additional principal payment, and we have already knocked a year off the loan.

We currently owe about $63,500. If we were to skip additional principal payments going forward, the loan will be paid off in six years. I am confident we can pay off the mortgage within five years.

We are 41 and 40. Our current annual income is about $120,000. We both contribute 15 percent of our income to our 401(k)s and expect to fully fund each of our Roth individual retirement accounts. The combined balance of all our retirement accounts is about $200,000. Our emergency fund can cover a little more than six months' worth of expenses. Our credit cards get paid off every month, and we have no other debt.

Our goal is to pay off our debt while paying the least amount as possible in interest. The shortest fixed-rate mortgage term I have seen advertised is a 10-year, and we are not interested in an ARM. If we were to proceed with no additional principal, we will pay an additional $9,200 in interest. Adding about $200 to our monthly payment will reduce the interest paid to about $7,500.

I realize that historically 4.75 percent is a good rate, but I am curious if there is a way to take advantage of refinancing at the record-low rates. Any suggestions you may have would be greatly appreciated.
-- Dave Denouement

AnswerDear Dave,
You're doing a lot of things right with your personal finances -- having an emergency fund, making retirement savings a priority, staying current on your credit card payments and paying down the mortgage. That's great!

I can understand the desire to capture today's lower interest rates in an attempt to reduce interest expense. With a relatively low mortgage balance and a focus on having the mortgage paid off in five years, you have to think hard about the cost-benefit analysis of refinancing.

You've identified your goal: Minimize interest expense on your mortgage. You don't want an adjustable-rate mortgage, or ARM, and you don't want to extend the term of your mortgage. But as long as there's no prepayment penalty, you can ramp up the additional principal payments on your mortgage so a 10-year mortgage is repaid in five years.

I think you should consider a hybrid ARM, namely a 5/1 ARM, for your refinancing. That guarantees an interest rate for five years, and given the Bankrate national average for a 5/1 ARM is 3.1 percent as of this writing, you can save even more in interest expense. You plan to have the mortgage paid off by the first interest reset date, so you're not taking on any interest rate risk.

If you do nothing, the remaining interest expense on your home is $9,200 with six years remaining on your mortgage. If you refinance, you expect to pay off the mortgage in five years. Assuming an interest rate of 3.1 percent, that brings the remaining interest expense to $5,200 -- a savings of about $4,000. If closing costs are less than $4,000, you save the difference in interest expense.

Closing costs are critical to the decision, and you typically don't know the exact closing costs until the day before closing. If they come in at $3,800, you're saving $200. I don't know about you, but I'd pay $200 not to sit through a mortgage closing. Keep in mind a no-cost closing is a misnomer. The costs get paid. They just bake them into the mortgage in some fashion, either as a higher interest rate on the loan or by adding to the loan balance. All of these approaches add to the interest expense, reducing the interest rate savings. You have to decide if it's worth chasing these lower rates.

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