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Dropping Rates

This is the most obvious reason to refinance. Say you got your original mortgage rate at 6.50 percent and rates have since dropped to 6.00 percent — and might move lower. As with any mortgage, there are closing costs involved. And you'll need a whole new round of fees similar to (and sometimes even more than) when you first bought the property. You'll need a new appraisal, a new credit report, a new title insurance policy, and more.

You may have heard or read somewhere that the way to know how to refinance is if rates drop 2 percent or more from your current rate. And, in fact, if rates did drop more than 2 percent it would be a good idea to refinance. But you probably shouldn't wait that long. In fact, rates haven't moved that much since mortgage rates hit a relative high in mid-2000, then dropped nearly 3 percent. Historically, however, at least over the past two decades we've seen rate moves typically within a i percent range over the course of one year. Up a little, down a little.

So is there a magic change in rate that works? Actually, no. Rates are a function of the loan amount and the term. You need to calculate the monthly payment and evaluate that first. Are rates and the payments essentially the same thing? Again, no. And here's why.

Calculate the payments on a 30-year 6.50 percent rate and a 7.00 percent rate on $500,000. You get $3,160 and $3,326 per month, respectively. Now do the same calculation, but on a $50,000 loan. The answer is $316 per month and $332 per month. Hold that thought for a moment.

We'll discuss closing costs for condos in detail in chapter 7, but say closing costs for a refinance add up to around $2,000.

When determining whether if s a good time to refinance, take the difference in monthly payments, not the difference in rate, and divide that into the closing costs. The result is the number of months it takes to “recover” those closing costs.

In this example, the difference in monthly payments on the $500,000 loan is $166 per month and on the $50,000 loan if s a $17 per month savings.

Divide the $166 savings into the $2,000 and the answer is 12.04, or 12 months to recover the closing costs needed to close the loan. Now divide the $17 monthly savings on the lower loan amount into the $2,000 worth of closing costs and the result is 117.6, or 118 months to recover the closing costs needed to close the transaction.

Do you see the difference? If s not the rate thafs important; if s how long it takes to recover closing costs. So, pay little attention to the rate and a lot of attention to how much it will cost you to refinance and how long it will take to recover your costs.

There really is no ideal “recovery” period for closing costs as long as you keep the mortgage long enough to get the costs back. But 118 is way too long — that's nearly 10 years! But any recovery period within two to three years would be appropriate.

Rate locks and terms for refinances work exactly like rate locks and terms for purchases; it's the very same loan, just applied differently. That being said, how far should you allow rates to drop before you lock in?

In other words, if rates go down to 6 percent and your recovery period is 12 months, should you wait to squeeze out an additional 1/8 percent or more? What if rates drop to 5.875 percent and you locked in at 6.00 percent?

I have seen this play out time and time again as I listened to my clients muse about how much further they thought rates would drop before they lock in.

Let's see how trying to squeeze out another 1/8 percent gain can affect the refinance numbers.

Five years ago, when a buyer bought her property, she got a 7 percent 30-year mortgage on $300,000. The principal and interest payment on that note comes out to $1,995 per month. But now rates have come down dramatically over the past few months and she can get another 30-year fixed rate at 6.25 percent. Her new payment would be $1,842 — a monthly savings of $153. She discusses the new rate with her loan officer and they determine together that it indeed is a good time to refinance.

But she wants to wait. She heard on the news that the Fed was likely to lower rates in the future and that the economy wasn't going to be out of the doldrums any time soon. In fact, many economists projected a recession. She thinks rates are going to dip further.

So she waited a couple of weeks and rates were still at 6.25 percent. Her loan officer encouraged her to lock in her rate and close the new deal, but she thought perhaps he was trying to get his commission check and had less regard for how rates might go lower.

She waited some more. And some more. In fact, three months went by while she was “playing the market” and waiting for rates to go down further. But she forgot to take into account that each month she waited she was throwing away money on the higher rate. After three months had passed, she lost $459 in savings, trying to get the rate to move down just a tad more.

While she was concentrating on the interest rate, she didn't consider what the rate actually represented: her mortgage payment. She would have locked in an interest rate at 6 1/8 percent if it became available, but rates were stubbornly in the 6.25 percent range.

A difference in 1/8 percent results in a drop in payment by only about $20 per month on her loan. If she divided that $20 into the $459 she “lost,” she would find out that by waiting three months to save $20 per month it would take 22.9 months to recover lost interest.

Her loan officer told her that the monthly payment wouldn't go down much more and that she'd already saved $153 by refinancing from the 7 percent rate. She said she'd think about it and would call him back the next day.

She did sleep on it, thinking how much mental stress she was causing herself wondering what rates were going to do, and if her magical 6 1/8 percent rate would be available the next day.

The next day she did indeed call her loan officer and asked him to lock her in at 6 1/4 percent. But he couldn't. That morning, an unemployment report was released by the government showing that many more people were back at work than had been estimated, and that the economy was growing instead of heading toward a recession.

That immediately translated into higher mortgage rates, causing the 6 1/4 percent rate to move up to 6 1/2 percent that very morning. Now she had to decide if she should wait to see if rates would go back down to 6 1/4 percent, the rate she could have gotten a few months earlier.

She decided she didn't want to go through all of that again and refinanced at 6 1/2 percent, dropping her payment to $1,896. Still a good deal, just not as good as she could have gotten.

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