How to tell if refinancing's a good deal

Since January, homeowners by the busloads have taken advantage of some of the lowest interest rates in years to refinance their homes.

Their shrewd refinancing deals may make them the buzz of the local cocktail party circuit, but rarely will they tell you how much they paid to get that dazzlingly low interest rate of 6.5% on a 30-year fixed. In just about every case, they paid plenty.

Borrowers who focus only on the interest rate can easily be snookered, experts say. They also should look at the transaction costs, which can be considerable.

Points are fees charged by lenders when the mortgage deal closes. Each point equals 1% of the amount borrowed, and they are typically the largest transaction cost. Lenders allow refinancing customers a choice: minimize transaction costs and pay a higher interest rate, or maximize transaction costs and pay a lower interest rate. A good credit risk willing to pay 3 or 4 points will end up with an astonishingly good interest rate, but the high cost may not be worth it.

Take a borrower of a $200,000 mortgage who pays $8,000 in points to reduce the interest rate on a 30-year mortgage from 7.25% to 6.5%. The lower rate saves $100 a month. It would take nearly 7 years to recoup the money spent to buy down that rate.

Mark Smokowicz, 47, of Saline, Mich., figured out the trade-offs early. He's been shopping to replace his 1-year adjustable-rate mortgage, now at 8.9%. He is looking to refinance $180,000 at a 30-year fixed rate.

"When I began a month ago, I was looking solely at the low interest rate, but the closing costs were enormous," says Smokowicz, a software marketer.

Smokowicz says the best interest rates he's seen carry closing costs of more than $10,000. He says he's decided to limit his closing costs, points and other charges, to about $6,000, or 3.3% of the loan amount, even though it'll bump his interest rate up by a fraction of a percentage point.

Making the decision

So how do you decide? Experts say refinancing shoppers have to determine first how long they plan to stay in their current home, and whether their expected tenure justifies going to the expense and inconvenience of refinancing. Homeowners within a few years of paying off their current mortgage also have to decide whether the transaction costs are worth it.

The Internet provides enormous help in calculating how long it would take for lower monthly house payments to offset the refinancing costs. Among the sites with handy calculators are www.domania.com, www.homepath.com and quickenloans.quicken.com.

In addition to projecting the time needed to recoup costs, borrowers should also consider the hassle just to save a few bucks a month, says Keith Gumbinger of mortgage tracker HSH Associates.

He warns borrowers to be careful of deals advertised as low-cost or no-cost refinancings. Customers will still be paying transaction costs through a higher interest rate, a higher refinanced loan balance or through a combination. Says Gumbinger: "It's not free; it's just that there's nothing out-of-pocket today."

Refinancing expenses are largely invisible because they're commonly just rolled into the balance of the new mortgage. But the government requires lenders not once but twice to lay out costs in writing.

The first required disclosure comes at the time of application and represents the lender's good faith estimate of closing costs. Receipt of the good faith estimate is a good time to clear up any misunderstandings or bail out of the deal. A more precise accounting of costs on a government-approved form is presented at closing. Even then, the law provides the borrower a few days to bail out of the deal before it's final.

Here are some of the charges that will be laid out in the written disclosures.

Points. In many parts of the country, lenders distinguish between origination points money to cover the lenders' costs and discount points money to reduce the interest rate. For the borrower, that distinction isn't important except that some loans advertised as "zero points" may be referring only to discount points, not origination points.

Mortgages typically come with zero to 4 points. According to HSH, use of points has been on the decline, and the average mortgage these days carries less than 1 point. In general, a point paid at settlement will reduce the interest rate of the mortgage from one-eighth to one-quarter percentage point.

Regardless of how your lender labels your points origination or discount the Internal Revenue Service views them the same for deductibility on income taxes, says Mildred Carter of CCH, publisher of tax information. Their tax treatment gets tricky, but generally speaking, taxpayers can't deduct the full amount of points in a refinancing in the year they're paid.

Re-appraisal. In most cases, the lender will require a professional appraiser to calculate the market value of your home on the basis of recent sales in the neighborhood. Expect to pay about $300.

You may be able to sidestep this cost if the appraisal for your existing mortgage is only a few months old, or if you're refinancing only the balance of your existing mortgage, and not tapping any additional equity.

Title insurance. Lenders require insurance against the possibility that a borrower may not have clear title to the property. The insurance pays off, for example, if an unknown creditor makes claim to the house to satisfy an old debt. It's expensive.

According to a recent industry study, the median charge for a title company to issue insurance and to oversee the closing of a mortgage deal is 82 cents per $100 of the loan amount, or $1,640 on a $200,000 mortgage. In many instances, the cost of insuring a title is discounted in a refinancing because ownership is not changing hands. The amount of discount depends on the state law and the length of time since the borrower last bought title insurance.

Prepaid escrow. This may appear to add thousands to the bottom line of the transaction, but it really doesn't. Your new mortgage company wants to be in the position to use your money to pay property taxes and hazard insurance premiums when they come due. You should have a balance of comparable size in the escrow account maintained by your old mortgage company. So you'll pay for a new escrow account at settlement, but you'll get a refund of the unspent balance from your old company. It's a wash.

Likewise, expect to pay a month's interest at closing. That money will be divided between your old and new lenders to square you up for the month in which you're closing. But don't count it as a closing cost because the interest payment at closing substitutes for a monthly mortgage payment that you won't have to make because you're refinancing.