60-Second Guide to Smart Refinancing

The financial industry is fond of rules-of-thumb, and it can regale you with plenty of tales on the topic of refinancing. But there’s a lot more to this big-ticket decision than simply deciding whether to do it based on a minimal interest rate movement or monthly mortgage savings.

You should apply the same rigor (or more) to getting your second or third or ninth loan as you did for your first. So let’s find out whether refinancing is a smart move for you to make:

0:60: Start with the Big Three questions
How long do you plan on staying in your home? Which way do you think interest rates are headed? Will fluctuating interest rates on your adjustable-rate mortgage keep you up at night? Your answers to these questions will tell you a lot about whether you should refinance. But they don’t tell you everything. As with so many financial decisions, it’s the details that matter. So let’s keep digging.

0:52: Review the terms of your loan
If you’re reading this, you may well have an adjustable-rate mortgage, also called an ARM. Despite all of the bad press, not all ARMs are “risky” — and they certainly aren’t all created equal. Get your loan paperwork out of the filing cabinet and start reviewing the terms of agreement and adjustments. The most troublesome loans carry frequently adjusting interest rates — anywhere from monthly to every six months — and payment options. (Not surprisingly, they also provide the biggest commissions for the brokers who sell them.) Traditional ARMs are those with longer-term adjustment periods. (Some of them come with an interest-only option.) Even if your ARM is due to reset soon, refinancing isn’t necessarily a slam-dunk decision. Home in on the rate adjustment and read on …

0:44: Determine how bad your rate adjustment will be
It’s not enough to say “I have a five-year ARM.” You need five key pieces of information:

• The index your rate is tied to.
• The date your loan adjusts.
• The annual adjustment cap.
• The lifetime adjustment cap.
• And — here’s the important one — the initial adjustment cap.

Rate increases tend to be fairly standardized on most ARMs (though five-year ARMs have been found to have greater variations than others). We emphasized that last item in the list above because it’s a small detail that can have huge long-term consequences. For example, the holder of a 6% loan with a 2% cap on the first rate adjustment could face rates as high as 8% when the rate adjusts. A borrower with a 5% initial rate cap will pay a whopping 11% interest rate. That’s quite a handicap right out of the gate.

0:32: Figure out your FIR
Find the index your ARM follows, as well as your margin, in your loan paperwork. You need this information to find your loan’s fully indexed rate (FIR) — the current rate of the index plus the margin. When the FIR is higher than the fixed-rate mortgage (FRM) rate, refinancing might make sense. Though if your ARM rate is currently below the FRM as well — and that’s the most common scenario — it makes sense to wait until the next adjustment to refinance, unless you are extremely risk-averse.

0:26: Calculate your actual break-even point
The guts of the refinancing decision comes down to this: Over the period of time you plan to stay in your home, will your savings from reduced mortgage payments be greater than the upfront costs?

Many borrowers follow a simple formula — the cost of the new loan divided by the reduction in the monthly mortgage bill — to determine how long they’ll have to stay in their home to recoup their money. Simple? Yes. Accurate? Not really.

This rule of thumb overlooks several important factors, such as:

• The difference between how much faster (or slower) you’ll pay off the new loan versus the old one.
• The amount of interest you could have earned on the money used to refinance — or, conversely, what you might earn on your savings from refinancing.
• Whether you’re rolling the costs of refinancing into your new mortgage. Doing so reduces your savings, because you’ll pay interest on that amount.
• Any pre-payment penalties — usually anywhere from one to three years — that would force you to pay as much as 3% of the original loan amount for an early exit.

None of these factors might be a deal-breaker, but they are important to include in your cost calculations if you want to be smart about refinancing.

0:12: Decide whether an ARM still fits your lifestyle
After all of that ARM wrestling, the choice of whether to refinance into a fixed-rate mortgage, get another ARM, or stay put comes down to how it meshes with your financial lifestyle. Maybe you chose an interest-only ARM because you had an unsteady income. Perhaps you didn’t expect to live in your home very long. No matter what the original reasoning, remember, plans change. It’s important to re-examine your original motivation and see whether those inputs have, too. Look at the equity you’ve built up. (Perhaps consolidating that piggyback loan is the right choice now.) Take a truthful look at how you’re handling that “freed-up” cash: Are you investing it or blowing it at the mall? Research home values, which affect your ability to move up or sell. Check your credit report, particularly if you were forced to take a subprime loan because of past bloopers.

0:03: Use your leverage, and make the refinancing deal
Finally, after you’ve made the decision that the smartest move you can make is to refinance, it’s time to strike a deal. Lenders know that refi customers hold more cards than purchase-loan customers do because they’re not up against a hard deadline. So take the time to find the right loan for your housing situation. We’re happy to walk you through the refinancing deal and help you shave some serious money off the tab.

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• The rest of our home collection offers a closer look at when refinancing is a good idea, along with much more.