Dear Dr. Don,
My husband and I are planning to refinance our home. Because we don’t have the funds to pay closing costs, they will be rolled into the new loan. Our balance right now is $150,000 and a monthly note of $1,024 paying 7 percent interest (conventional). We had no closing costs when we purchased the home 2.5 years ago. (The bank paid all the closing costs.) We are also not paying mortgage insurance premiums, or MIPs.

Under the new financing, we are looking at a Federal Housing Administration, or FHA, five-year adjustable-rate mortgage with 3.875 percent for the first five years. The new balance, including closing costs, will be $160,000. The new monthly note will be $754. We can refinance after five years under FHA with a streamlined process if interest rates go up. The rate can only go up 2 percent at a time.

Is it better to stay where we are given that our loan balance will increase $10,000? We don’t know whether we will stay in the home after five years or not — since the kids will be out of the house. We are trying to lower the monthly payment now to help pay for two kids in college.
— Janis Juncture

Dear Janis,
You want to know if it’s a good idea to invest $10,000 today in closing costs and mortgage insurance premiums to refinance into a 5/1 adjustable-rate mortgage. That’s a pretty expensive closing, even with the FHA MIP. You should ask the lender for a breakdown of those costs. Paying points will raise the annual percentage rate on the loan, along with increasing the closing costs. Make sure you understand how the MIP is paid at closing and over the life of the loan.

I think refinancing to get out from under a 7 percent mortgage is a good idea if your credit scores and finances allow. I’m less enamored with the idea of a 5/1 ARM if you’re planning on being in the house for more than five years. Interest rates are near historic lows — why take on the interest rate risk in the out years on the 5/1 ARM when you can lock in an attractive fixed rate today?

The rate on your 5/1 ARM may be capped at 2 percent at first reset five years from now, or 5.875 percent, but you’d also want to look at the lifetime cap on the ARM. A couple of back-to-back 2 percent increases in rates wouldn’t take long to make this mortgage a burden.

You can use Bankrate’s mortgage refinancing break-even calculator to estimate the break-even on the mortgage and the interest savings, although you can’t put too much stock in the numbers out past the fifth year, when the loan resets.

Read more about refinance.

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