4 great reasons to refinance now

Hand signing mortgage next to money and house

Mortgage rates are on their way down, with many hitting levels not seen since July 2003.

There's a twofold reason for this: the Federal Reserve is using all of its weapons to try to get the economy rolling again, and to this end, it cut short-term interest rates to near zero, allowing banks to borrow money for almost nothing.

In addition, the government is backing 90% of all mortgages issued, and the Federal Reserve has promised to buy more mortgage-backed securities and direct debt from Fannie Mae and Freddie Mac. It's also considering buying long-term Treasuries. This is a boost of confidence for lenders.

Our most recent survey taken Dec. 31 found the average interest rate for a 30-year, fixed-rate loan was 5.64%. But a search of our extensive database of the best mortgage rates from across the country shows lots of lenders offering loans at 5.25% or less, with fees under $1,000.

That means you should seriously consider refinancing if:

Although rates are important, the key to a successful refinancing is staying in the house long enough to recover the cost of a new loan.

If, for example, refinancing cuts your payments by $100 a month, but you paid $2,000 in closing costs to obtain the new loan, you would have to live in that house for 20 months before you actually begin saving.

With that in mind, take a look at our 4 great reasons to refinance your mortgage and see if they can help you.

Reason 1. Lower your monthly payment.

An old rule of thumb says you shouldn't refinance unless you can save two percentage points on your mortgage rate. But if you can save even one percentage point, you're throwing money away every month by not refinancing.

If you're interest rate is 6.5%, you're paying $632 on every $100,000 you borrowed. Refinance into a 5.25% mortgage and your payments drop to $552 a month -- that's a savings of $80 a month or $960 a year on every $100,000.

If you can get a new loan cheaply enough -- fees of $1,000 or less -- you probably would be able to pay off a credit card or do some much-needed home repairs with your savings.

Reason 2. Get out of an increasingly expensive adjustable-rate mortgage.

Many borrowers over the past few years were given artificially low introductory or "teaser" rates on adjustable-rate mortgages. If that rate is about to end -- or has already ended and begun to rise -- you should refinance.

While that initial rate was probably less than you could get on a fixed-rate loan, the new rates will be higher -- maybe much higher.

That's because lenders determine how much they charge on an ARM by taking a benchmark interest rate -- such as what the government is paying to borrow money for a year -- and adding a premium or margin. If your credit is good, that might be 2.5 percentage points. If your credit isn't so good, it might be as much as seven percentage points. (If you're unsure about your loan, check the mortgage documents. The formula is spelled out there.)

Although you might want to refinance to a 30-year, fixed-rate loan, the lower your credit score, the more difficult it will be for you to qualify. Borrowers with credit scores below 620, who must apply for high-cost subprime loans, probably will be turned down.

When you apply, lenders will want to document every aspect of an application, especially your income and assets -- something they frequently ignored just a year or so ago.

They're also demanding that you have at least some equity in the home -- a huge problem for borrowers who put no money down or financed the entire purchase with negative amortization loans that allowed their debt to grow. Meanwhile, home values have fallen, leaving homeowners owing more than the home is worth. This leaves them unable to sell or refinance without coming up with cash to make up the difference.

Reason 3. Free up cash from your home.

High on the list of reasons to refinance is the popular "cash-out" refinancing that allows you to borrow more than you owe on your current loan and pocket the difference.

Let's say you owe $100,000 on a $200,000 home. You could refinance for $125,000, pay off the $100,000 balance on the old mortgage and keep $25,000 for yourself. That's an attractive option now that low interest rates are available.

With good credit, most lenders will allow you to refinance up to 80% of your equity -- in this case, $80,000. Generally, we do not advise taking 80%, but it's there if you need it.

According to Freddie Mac, a government-owned agency that buys, packages and resells mortgages to investors, 83% of all the refinanced loans it bought between April and June 2007 were cash-out deals. That percentage fell sharply over the next few quarters but it is on the rise again.

If you can lower the interest rate on your mortgage and get cash out at the same time, that's a smart move. But if you simply want to tap into the equity in your home, getting a home equity line of credit (HELOC) would be more cost effective. Right now, HELOCs cost 5% or less, and there is usually no cost to open a line of credit. Spending that money on home repairs, credit card debt, unexpected medical bills or your kid's college tuition makes good financial sense.

Reason 4. Reduce your interest payments.

If you can handle higher monthly payments, you can save in the long run by refinancing into a shorter-term mortgage.

Switching from a 30-year at 5.25% to a 15-year loan at 4.75% means your total monthly payments would grow from $632 to $778 for every $100,000 you owe, because you'd be paying the principal back twice as fast.

But you'll ultimately save money two ways:

But only do this if you are in the first 10 years of your 30-year loan, or if the 15-year rate is extremely low. Have your lender run some numbers on how much you would save in interest before you decide.

If you can't swing the 15-year payments, check the numbers on a 20-year mortgage. You could save close to $40,000 at 5.25% interest by choosing a 20-year over a 30-year mortgage.

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