Thursday, March 21, 2013

Run the numbers before doing a "no-cost" refinancing


When lenders admonish you to refinance your mortgage because "interest rates are at historic lows," they aren't kidding. Just ask anyone who lived through the late 1970s when mortgage interest rates climbed to over 15%. But when you refinance a mortgage, it's especially important to slow down, read the fine print, and beware of offers that sound too good to be true. As many economists have preached, "There's no such thing as a free lunch." In other words, don't expect to get something for nothing.

That maxim holds true even with "no-cost" refinancing. You may skate through the refinancing process without opening your wallet or writing a single check, but be assured that someone will cover the costs. After all, appraisers need to be paid. Title companies charge for conducting title searches. Setting up title insurance isn't free. Lenders, escrow agencies, local governments — all want payment for their role in refinancing your mortgage.

In a "no-cost" refinancing, how are such routine closing costs covered? A lender might simply roll the closing expenses into the balance of your new mortgage. You might refinance a mortgage to reduce your monthly payment and total interest expense. But if a lender adds closing costs to your new mortgage, you may find that the benefit of that lower interest rate disappears. That's especially true if you end up with a larger mortgage balance over a longer term.

A lender might also increase the interest rate on the mortgage to cover closing costs without passing them on to you — at least initially. You don't pay the costs upfront, but the lender recovers those costs over the term of the loan because you're paying more interest.

Let's say you apply for a "no-cost" refinance of your $150,000 mortgage. The refinanced mortgage will be paid off in 15 years. If one mortgage has a fixed annual rate of 4.5%, you'll pay about $56,500 in interest; if the interest rate is increased by just half a percent to 5%, your total interest will be $63,500 and your monthly payment (principal and interest) will be about $40 more. Accordingly, it may make more sense to pay the closing costs upfront and avoid the higher interest rate.
Bottom line: Be sure to do the math before signing papers on that "no-cost" refinance.

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