Should I refinance interest-only loan?

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EDITOR’S NOTE: Refinancing activity is soaring, so Bankrate asked personal finance columnist Dr. Don Taylor to answer some of our readers’ most pressing questions about getting a new mortgage.

Dear Dr. Don,
As interest rates creep lower and lower, I feel inclined to run the numbers for my own mortgage. Unfortunately, it’s proving very difficult since we have a five-year adjustable-rate mortgage that is interest-only for the first 10 years.

None of the refinancing calculators I’ve found give you the option to factor in ARMs or interest-only clauses when determining the break-even point. Are there any calculators that take into account ARMs and the forgone equity when refinancing to a fixed-rate mortgage?
— Dominic Decides

Dear Dominic,
It is a problem. It gets worse once you realize that the break-even point isn’t a very useful financial measure, either.

The break-even model looks at the reduced payment versus closing costs. If refinancing reduces your monthly nut by $250 and you paid $5,000 in closing costs, the break-even point is 20 months ($5,000/$250 = 20).

This is a rule of thumb. It’s useful, but not something you want to bend over backward to emulate when deciding whether it makes sense to refinance your tricked-out 5/1 interest-only ARM.

Most homeowners are in an interest-only ARM for one of two reasons. Either they can’t afford the mortgage payment if it includes a principal repayment component, or they have something better to do with the money that would have gone toward principal repayment.

Do you have something better to do with the money than prepay your mortgage? If so, a better approach in analyzing a refinancing is to compare estimated total interest expense, the opportunity cost associated with paying the closing costs on the new loan and the investment returns associated with not prepaying the mortgage. Don’t forget the tax impact of all these actions.

The refinancing calculator that comes the closest to all of this is available on The Mortgage Professor’s Web site. It doesn’t handle the interest-only issue but it handles almost everything else. Another good choice is the calculator available on the CCH Financial Planning Toolkit Web site.

Does a refinance make sense for you? Try Bankrate’s refinance calculator to find out how much you might save.