To Refinance or Not Refinance

by mike on December 7, 2009

I got a call the other day from a client who was asking if he should refinance his mortgage.  I get this question a lot, so let’s take a look at some fundamentals of refinancing and mortgages in general.

1.     Regular vs. Streamline.

This particular person could refinance an FHA loan that he currently held.  He could save 1% compared to his current rate if he took this route.  He could do a conventional loan and save about 1 ½%.  The main reason for the difference is that the FHA loan rolls the closing costs into the rate.  The regular, conventional refinance is usually better than a streamline because of the better rate.  A streamline is a type of FHA loan that requires very little documentation.  So, if you happen to have some dings (or craters for that matter) on your credit, the streamline refinance is a better option.  The reason is because you do not have to qualify for the streamline; they just do it.  So, if your credit is good, conventional is better; if your credit is bad, streamline is better.

2.     When does it make sense?

The ultimate question my client had was if he should do a refinance.  The industry term for how to figure this out is to do a break-even analysis.  Basically, you need to do some math.  For example, let’s say the mortgage balance is $100,000.  If you can save 1%, you would save $1,000 per year.  If the closing costs are $3,000, it would take 3 years to break even.  So, if you plan on being in the house for more than 3 years, it is worth it.  A common rule of thumb is that you break even in three years or less.  So, if you’re closing costs were $5,000 or you would only save 1/2% ($500 per year) and closing costs were still $3,000, then it wouldn’t be worth it.  Another rule of thumb is if you can save 2% on your rate, it is a no-brainer.  It still doesn’t hurt to do the math anyway.

3.     General mortgage guidelines.

Since we are on the topic of mortgages, I thought I would summarize the guidelines I recommend when buying a house.  I recommend taking out a 15 year fixed rate mortgage.  You should have at least 20% of the price of the house or more to use as a down payment.  That way you avoid private mortgage insurance, commonly referred to as PMI.  Finally, the payment should be no more than 25% of your take home pay.  Follow these guidelines and you will be on your way to financial success and can avoid becoming house poor.

If you have any questions about if you should refinance , feel free to e-mail me at [email protected] or give me a call at 217-740-6632.   I can walk you through a break-even analysis and see if it makes sense in your situation.  Also, if you need more explanation on any of my mortgage guidelines, please let me know and I would be more than glad to explain.

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