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Cover story: To refinance or not? Variables are many
Question of the Day
Adjustable-rate mortgages (ARMs) have garnered some bad press during the recent housing crisis, often getting lumped in with other types of mortgages, such as interest-only, zero-down-payment and "pay-what-you-want" loans, as products that could be dangerous for homeowners.
In recent months, particularly as mortgage interest rates have dropped to historically low levels, many homeowners with ARMs have been refinancing into fixed-rate loans. Homebuyers primarily are opting for fixed-rate loans, too. In fact, the Mortgage Bankers Association Weekly Mortgage Applications Survey typically shows that applications for fixed-rate mortgages currently represent approximately 80 percent of all mortgage applications.
Homeowners who have an ARM may feel a little panicky and pushed to refinance out of fear that their mortgage rates will rise when their loan "resets" - when the fixed-rate period of their loan ends and the mortgage rate begins to adjust regularly.
ARMs are offered with a one-year, three-year, five-year, seven-year or, occasionally, 10-year fixed rate before the rate begins to adjust, usually annually. Lenders suggest that borrowers review their ARM terms carefully before automatically rushing to refinance because, with interest rates extremely low, their adjusted mortgage rates are not likely to result in more costly monthly payments.
"Before anyone makes any decision about refinancing out of an ARM, they should really take a careful look at their loan," says Alex Lieb, operations manager for Access Capital Mortgage, an affiliate of Presidential Bank in Bethesda, Md. "If their loan has reset recently or is about to, and the index their loan is tied to is lower, then their payments may stay the same. For some people, their payments could even be lower."
Mr. Lieb says refinancing may not make sense for some of these ARM borrowers, particularly if they are going to sell their home in the next year or so.
Many ARMs are linked to the LIBOR - London Interbank Offered Rate - index, which is has remained low throughout 2010.
"People who plan to stay in their property for just another one or two years should probably consider keeping their ARM to enjoy these low rates, since most people think mortgage rates are likely to stay this low for at least a year or two," says Steve Cohen, vice president and mortgage originator at First Place Bank in Rockville, Md.
"For homeowners who expect to stay longer than another couple of years, it probably makes more sense to lock in a fixed-rate mortgage at these low rates to make sure they keep them for their entire loan."
Mr. Cohen points out that even people who plan to move soon may want to consider a fixed-rate loan.
"People can't always plan everything the way they think they can, and they don't always know for certain that they will be able to sell, even if they must move," Mr. Cohen says. "It may be necessary to keep the property as a rental, in which case, having a fixed mortgage can be a big benefit for cash flow."
Whether you have an ARM or a fixed-rate mortgage, if you are considering refinancing, it is important to evaluate your goals carefully before following the crowd and applying for a new loan. First, think about how long you expect to stay in your home. Refinancing generally costs 3 percent to 6 percent of the mortgage loan, so it should not be undertaken by homeowners who plan to move soon and will not have time to recoup their expenses.
Next, establish whether the goal is to reduce the overall interest paid on the home loan, lower the monthly payment, own the home without a mortgage as soon as possible or use the home equity to pay off debt or make a home improvement. All of these are valid reasons to refinance, but each goal may result in a different choice for a new loan program.
After evaluating their goal for refinancing as part of their overall financial plan, homeowners, whether they have an ARM or a fixed-rate loan, should contact a lender to discuss their options for refinancing.
"Homeowners with an ARM that is about to reset will receive a notice about their new rate," Mr. Lieb says. "At that time, they should contact their lender to talk about the possibilities for refinancing and compare their options with another lender, too."
In addition to comparing mortgage loan rates, homeowners should compare their options for paying closing costs. Lenders sometimes are able to offer a "no-cost" refinance, in which the lender pays all costs. A no-cost refinance typically has a slightly higher interest rate than a mortgage with closing costs. Borrowers who choose to pay closing costs can pay them upfront or wrap the costs into the loan if they have sufficient equity in the home.
"If you plan to stay in your home for five years or less, you may be better off doing a no-closing-cost loan," Mr. Lieb says. "If you plan to stay longer, you will be better off in the long run paying those costs because you will be paying a lower interest rate for the entire loan period."
In addition to discussing loan options with a lender, borrowers can use a mortgage refinancing calculator, such as the one available from Bankrate.com (www.bank rate.com/calculators/mortgages/refinance-calculator.aspx). This calculator evaluates the difference in mortgage payments from one loan to the next and compares this difference to the cost of refinancing to find out how long it will take to recoup your expenses.
While plenty of homeowners would like to take advantage of refinancing into today's low mortgage rates, not everyone will qualify. The two biggest obstacles to refinancing are home values and credit scores. As home values have dropped, some homeowners who once had 20 percent or more equity in their home are discovering they have low - or even no - equity in their property. Equity is the difference between the current home value and the amount due on the existing mortgage and all other liens, such as a home equity line of credit.
"The good news is that many homeowners can refinance even if they have low equity because of government programs in place for loans owned by Freddie Mac and Fannie Mae," Mr. Cohen says.
Mr. Lieb recommends that homeowners with low equity check with their lender to see if they qualify for a refinance. He says some lenders will refinance up to 120 percent or 125 percent of the home's current value.
Borrowers with low equity who do not qualify for a special government program will have to pay private mortgage insurance (PMI) if their equity is less than 20 percent, even if they have not been paying PMI with their current loan.
"A lender can calculate the difference in payments with different scenarios, but for many people it would still make sense for them to refinance even if they have to start paying PMI," Mr. Cohen says. "For example, if you are going from a 6.5 [percent] interest rate to a 4.5 [percent] interest rate, even with adding PMI you are likely to have lower monthly payments. Also, for most people, PMI payments are now tax deductible."
Another option for homeowners with cash available is to pay down the principal on their existing loan to qualify for a new loan without paying PMI. Some borrowers are opting to pay down their loan balance to qualify for a new loan regardless of whether they would need to pay PMI.
Homeowners who have not applied for a new loan in several years may not be aware that lenders have stricter guidelines for borrowers in terms of their credit score and their debt-to-income ratio, regardless of whether they have been paying their mortgage on time.
"Lenders are credit-sensitive now, and so only borrowers with a credit score of 740 and above will qualify for the lowest mortgage rates," Mr. Cohen says. "Consumers with scores from 700 to 740 may pay a slightly higher interest rate of about one-eighth to one-fourth of a percent higher.
"If you contact a lender, you can find out your credit score and get an assessment of what you might need to do to improve your credit score, if necessary. But probably, even if you have to pay a slightly higher rate, you will still be better off than what you are paying now on your mortgage."
Mr. Lieb says the bare minimum credit score to qualify for most loans now is 620, but, he says, consumers should understand that a variety of factors goes into the credit decision.
"Even someone with a credit score of 680 might not qualify, depending on the reason for their score, such as having too many credit lines open or using too much credit compared with the credit limit," Mr. Lieb says. "If they are having a dispute with a creditor that shows up on their credit report, that could cause the underwriter to deny the loan, at least until the dispute is cleared up."
Lenders must follow guidelines for debt-to-income ratios now, as well, so some borrowers may not qualify if their monthly minimum debt payments require more than 40 percent to 45 percent of their gross monthly income.
Another potential obstacle is the existence of a second mortgage.
"Homeowners can choose to combine their two loans when refinancing, or they can keep their second loan, as long as that lender is willing to agree to keep that loan subordinate to the new first mortgage," Mr. Cohen says. "Most lenders are agreeing to do that now, but it will add time to the refinancing process."
Homeowners with ARMs or fixed-rate mortgages should consult with a trustworthy lender to see what options are available to meet their specific circumstances. For some, keeping their current loan may be the best choice.
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