With the economy in a questionable state of flux, cash flow for many families is an ongoing challenge. From skyrocketing weekly supermarket bills to the ever-increasing cost of commuting to work and keeping the family vehicles on the road, our hard-earned dollars just don't go as far as they once did. For those families that made the decision to purchase their home and build equity for the future, the monthly mortgage payment most likely takes the biggest bite out of the family budget. Although the weak economy is, overall, a negative factor in most aspects of life, it has resulted in a considerable drop in mortgage rates over recent months. In addition, moves by the Federal Reserve to motivate spending have led to reductions in the interest rate banks pay to nearly 0% which has, in turn, brought mortgage interest rates to near historic lows. In just three years the average fixed interest rate for a 30-year mortgage has dropped nearly 2 percentage points. When you consider that in the early days of a 30-year mortgage, the majority of your payment goes towards the interest on the loan, a 2% difference in the amount of interest you are paying can mean a considerable reduction in your monthly payment. If you have a mortgage, it may be time to consider refinancing.

According to the Federal Reserve Board, refinancing a mortgage involves many of the same procedures and fees that were involved when you obtained your original mortgage. The big question to answer before refinancing is how soon the savings from a lower interest rate will be realized in covering the new set of closing costs that you must pay to refinance. With the potential benefits of refinancing, there are also several costs to consider.

The Federal Reserve notes that lower interest rates can come from a couple different situations including market conditions or because your credit score has improved. To illustrate the potential savings with just a .5% change in a mortgage interest rate, the Federal Reserve points to the following comparison of the monthly payments (principal and interest) on a 30-year fixed-rate loan of $200,000 at 5.5% and 6.0%:

The Federal Reserve adds that when considering a refinancing option, you may also want to consider decreasing the term of your mortgage since a 15-year mortgage typically carries a lower interest rate than a 30-year mortgage. There is, however, a tradeoff in that the monthly payments are usually higher since you are paying off a higher percentage of the loan principal with each monthly payment. Once again, the Federal Reserve offers a comparison of the total interest costs for a fixed-rate loan of $200,000 at 6% for 30 years with a fixed-rate loan at 5.5% for 15 years:

For those who are considering refinancing, the Federal Reserve provides some guidelines for help in determining when refinancing may NOT be a good idea:

• You have had your mortgage for a long time. Over the course of a 30-year mortgage, a greater percentage of your payment goes to the principal with each passing year while the amount credited to interest decreases. As more of your payment goes to the principal of the loan, you build more and more equity in your home. If you refinance in the later years of your mortgage, the process starts over and most of your monthly payment will go towards paying interest as opposed to building equity by paying on the principal.
• Your current mortgage has a prepayment penalty. Some mortgage lenders incorporate a prepayment penalty into their mortgage loans that goes into effect if you pay off the mortgage loan early, even if it is through refinancing. Any prepayment costs should be calculated into your breakeven analysis.
• You plan to move from your home in the next few years. By determining the amount of time it will take for you to cover the cost of refinancing, it will help you determine if the decision is wise given any plans to move in the near future.

Many of the fees involved with refinancing are the same for a homebuyer as when first making a home purchase. As the Federal Reserve notes, when you refinance, you pay off your existing mortgage and create a new one. Some of the typical fees and costs you will encounter while investigating the refinancing option are outlined by the Federal Reserve and include the following:

Application fee. This is a charge the covers the initial costs of processing your loan request and checking your credit report. If the loan is denied, you may still be required to pay this fee.

Appraisal fee. This fee pays for the appraisal of your home which is necessary to assure lenders that the property is worth at least as much as the amount of the loan. You are entitled to a copy of the appraisal but you must ask your lender for it. If you are refinancing or have had a recent appraisal you may ask to see if the lender is willing to forego the requirement of a new appraisal.

Attorney review/closing fee. These fees will be paid to the lawyer or closing company that conducts the closing for the lender.

FHA, RDS, or VA fees or PMI (private mortgage insurance). Such fees may be required for loans that are insured by any of the federal government housing programs. (Federal Housing Administration, Rural Development Services, or Department of Veterans Affairs). Both government and private mortgage insurance provide the lender with insurance coverage in the event that you do not make all the loan payments.

Homeowner's insurance. The lender will require that a homeowner's insurance policy be in effect at the time of closing/settlement. In some areas, lenders may also require proof of flood insurance so be certain to check with your lender to see if your home is in a flood zone.

Inspection fee. This fee covers any termite inspection or analysis of the structural condition of the property that the lender may require.

Loan origination fee. This is a fee charged by the lender to evaluate and prepare your mortgage loan.

Points. A point equals 1% of the amount of your mortgage loan. Loan discount points are a one-time charge you pay to reduce the interest rate of your loan, but some lenders charge points simply in order to earn more money on the loan, with no benefit to the borrower.

Prepayment penalty. As mentioned previously, some lenders charge a prepayment penalty if an existing mortgage is paid off early. In general, any loans guaranteed by the federal government cannot include a prepayment penalty, and some states also prohibit such fees.

Survey fee. The lender may require a survey of the property to confirm the location of any buildings and/or improvements on the property.

Title search and title insurance. These fees cover the cost of searching the property's records to make sure that you are the rightful owner and that there are no other liens against the property. Title insurance protects the lender in case there are any errors that occur in the title search.

The Federal Reserve states that is not unusual to pay 3% to 6% of the outstanding principal in refinancing fees. When researching refinancing options, a mortgage lender will provide you with a "good faith estimate" of the total fees for which you will be responsible at closing. You should use this estimate when conducting your own breakeven analysis for your particular situation.

In addition, the Federal Reserve suggests shopping around for the best rates when considering refinancing an existing mortgage. When lenders compete for your business, they may be willing to waive certain fees, saving you additional money upfront. The Federal Reserve also warns consumers about so-called "no-cost" refinancing which lenders advertise as a way for consumers to avoid paying up-front fees. There are two typical ways lenders promote the "no-cost" option. First, the lender offers an arrangement in which the lender covers the closing costs but charges you a higher interest rate which you will be required to pay for the duration of the loan. Second, the lender will include the refinancing fees into the final loan amount. Although you will not be paying cash for the fees at closing, you will repay the fees, with interest, over the term of the loan.

The prospect of refinancing an existing mortgage involves some homework on your part. Although the situation may be a good move for many families, each situation is unique and what may be a good move for one family may not be right for another. Talk to reputable lenders and gather information that will help you make an educated decision in consultation with your financial advisor. After all, when it comes to the price of a new home in today's market, a few percentage points of interest can amount to a huge savings for your family over the next twenty years.

As with any financial situation, consult with your financial advisor and/or tax consultant regarding your particular situation.

Sources:
Federal Reserve—www.federalreserve.gov
Federal Citizen Information Center—www.pueblo.gsa.gov

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