Mortgage Envy and Crunching the Numbers

In the 1970s, baby boomers pounced on their first homes and reveled as inflation drove up their prices overnight. A key point of one-upmanship was to have a house that appreciated faster than the next guy's.

Today, as mortgage rates touch 30-year lows, the truly smug boomer is one who just refinanced at a better rate than his neighbor.

At the same time, though, many homeowners are simply watching this spectacle and agonizing: Should I refinance? If so, what kind of loan should I get, fixed or adjustable? Fifteen years or 30? What if I just refinanced a couple of years ago? Or a few months ago? Should I take cash out? What about points?

It's not just cocktail-party bragging rights that are at play here. It's the steady drumbeat that tells Americans they must get smart about their money. And so homeowners sit and fret, afraid to move, afraid not to, even if not doing anything might be the "smart" thing to do. So, what's the answer? Make that answers, plural -- and the best answers depend greatly on the specific circumstances of the homeowner. In the view of many experts, however, sorting through the maze is well worth the time and effort for many people. Current rates are low indeed, and while it's possible they could edge lower if the economy weakens further, financial planners and other experts suggest that homeowners get going now and not worry about catching the absolute bottom.

In Washington, where all aspects of life are open to competition, this may cause a certain amount of psychic pain, but failing to act may be worse. Planners here say they know of a surprising number of homeowners still holding higher-rate mortgages because in earlier downturns they waited to try to get that very last eighth of a point and missed the opportunity entirely.

This form of infantile paralysis can be very expensive, and it overlooks the reality that an eighth of a point may not be much money compared with continuing to hold an old loan with a rate two or three percentage points higher.

Adding to the confusion is the fact that there are circumstances when it doesn't make sense to refinance, even in times like these.

Take a look at some numbers:

Mortgage rates are hovering at levels unseen since the 1960s. As of last week, many lenders were quoting annual percentage rates (the interest rate plus points) of between 6 and 6 1/4 percent for a 30-year fixed-rate loan, and a few were under 6, according to Bank Rate Monitor (www.bankrate.com).

Freddie Mac, the nation's second-largest buyer of home mortgages, said that the average 30-year rate reached 6.22 percent last week, down from 6.27 percent the week before. That matched the rate of Aug. 16, which was the lowest since Freddie Mac began keeping records in 1971.

The average rate on 15-year loans fell to 5.64 percent from 5.71 percent, up slightly from two weeks ago, when it hit 5.63 percent. The average rate on a one-year adjustable mortgage last week was 4.34 percent.

So what does an eighth of a point mean? Not all that much.

On a $ 150,000, 30-year mortgage, for example, the difference between a 6 percent rate and a 6 1/8 percent rate is about $ 12 a month.

But on that same $ 150,000 mortgage, total interest costs over 30 years would come to $ 246,230 at 8 percent but would fall to $ 178,107 at 6 1/8 percent and to $ 173,755 at 6 percent. The monthly payment would be $ 1,100.65 at 8 percent, vs. $ 911.42 at 6 1/8 and $ 899.33 at 6.

On a $ 250,000, 30-year mortgage, interest costs would total $ 410,390 at 8 percent, $ 296,846 at 6 1/8 percent and $ 289,593 at 6 percent. The monthly payment would be $ 1,834.41 at 8 percent, $ 1,519.03 at 6 1/8 and $ 1,498.88 at 6.

So while it's nice to get the very lowest rate, even the nearly lowest can yield big savings.

But those numbers are for the entire life of the loan. Refinancers by definition already have a mortgage and will have paid some of it down. So there are other questions that should be addressed.

"People who refinance their mortgage often look strictly at the payment. They neglect to look at the change in term or balance," said Elissa Buie of the Financial Planning Group Inc. in Falls Church.

It pays to be systematic, she and others said.

Here are some points to analyze:

* Will I benefit from refinancing? Most people will, but not everybody. The old rule of thumb was that if you could cut your rate by two percentage points, do it. But, as most homeowners already know, things are not that simple these days.

There are costs involved in refinancing, and unless you will be in your house long enough to recover them, it's not worth it. You can get a pretty good idea of how much you'll have to pay in fees and other costs by calling some lenders. Your current lender is a good place to start -- some lenders are interested in keeping your business and may offer you a good deal. If your loan is fairly recent, they may figure they don't have to make you jump through all of the hoops, such as getting a new appraisal, which can also save you money.

Once you have a handle on the costs, see how long it will take you to recover those outlays through reduced monthly payments. If you expect to be in the house longer than that, then refinancing looks good.

In other words, if your closing costs are, say, $ 2,400 and your payment drops by $ 100 a month, you'll need two years to recover your expenses.

And don't lose sight of your overall interest costs.

Consider the case of a homeowner halfway through a 15-year mortgage, who will have already paid back a third of the principal and will now be paying more principal than interest. Refinancing the remaining balance back out to 15 years will sharply reduce the payment but is very likely to increase the total interest expense.

It may be hard to pass up a chance for an even lower rate, but people in this situation can console themselves by figuring how much interest they will pay if they continue with their present loan vs. how much interest, plus closing costs, they would pay if they refinance the current balance for another 15 years.

In the vast majority of cases, they will find that keeping the current loan is cheaper overall, and when friends boast of their rock-bottom rates they can reply, well, mine clicks off entirely in fill-in-the-blank years.

People in this situation can also consider making extra payments of principal. This shortens the term of the loan and also cuts down the total interest paid.

The Internet is full of mortgage-interest calculators, many of which will allow you to figure how much interest you'd pay if you kept your present loan vs. how much you'd pay if you refinanced the balance. One such is at www.interestratecalculator.com/mortgage/mortgage.html, or you can go into a search engine such as Google.com and type in "mortgage interest calculator."

* How much should I borrow? If you've had your current mortgage a while, you will have paid down the principal balance a bit, maybe a lot. When you refinance, you can hold your new loan to that lower balance and further lower your payment because you're borrowing less. Or you may be able to borrow more, keeping the payment the same and taking cash away from the closing. But be careful about this. If you have a good use for the money, such as paying off high-cost debt, college costs, home improvements or a great investment you know about, then this is a cheap source of funds. But don't borrow if you're likely to fritter away the cash on current consumption.

* How long should I borrow it for? The 30-year mortgage has been the industry standard for some time now, but the 15-year is gaining. The advantage of a longer mortgage is a lower payment, and very long loans also put inflation to work for you as you pay back with cheaper and cheaper dollars. Lenders are not unaware of this, of course, which is why longer loans have higher interest rates -- but even so, those payments get easier and easier to handle as time passes.

But interest is essentially rent you pay to use someone else's money, and the longer you keep that money, the more total interest you pay.

If you are confident you would take the savings from the lower payments and invest them successfully, a longer mortgage makes sense.

"But there's the discipline issue," said Financial Planning Group's Buie. "It's fine and dandy to say if my mortgage [payment] was $ 300 less then I could save $ 300 more. But you know yourself -- are you really going to do that?"

Or, if you are younger, have a family and really need that extra cash, the choice may also be clear.

But if you are older, are near retirement and would like to time things so that when you retire and your income falls, your mortgage payments also go away, a shorter-term loan can fill the bill. This question is partly financial and partly psychological, but the value of the security of a paid-for house is considerable.

The stock market decline has made many people more conscious of risk than they used to be, Buie said.

"Would I simply sleep better having less mortgage? . . . Have I found out some things about myself in this recent economy I didn't know? Do I have less risk tolerance than I thought?" she asked. If so, then building equity and getting rid of debt are important stress relievers.

Many older baby boomers are choosing this route, accounting for much of the growth in 15-year loans.

But keep one thing in mind: When you refinance, if you go back to the same term you had before, you have effectively stretched out your loan. That lowers the payments but raises the total interest cost. In other words, if you have had a 30-year loan for five years, there are 25 years left to go on it. If you then refinance it at 30 years, you've added five years to your debt -- and five years of interest costs.

* Should I take a fixed rate or an adjustable rate? Rates on adjustable-rate mortgages, or ARMs, are very low, and thus very tempting. But with interest rates as low as they are today, it's hard to imagine that they have any place to go but up. So if you plan to remain in your home for many years, locking in today's levels looks like a good bet. And, of course, if rates were to plunge, you could refinance again.

But if your time horizon is five to seven years, an ARM may work. If you expect to be transferred or plan to retire and move, you may be able to come out ahead even if rates do rise. Most ARMs have limits or caps on the amount their interest rates can be adjusted, so the very low rates in the early years can keep you ahead for a while in total cost even if rates do rise.

* Should I pay points for a lower rate? If interest is like rent on money, then points are like prepaid rent. If you prepay, say, a car rental, then turn the car in early, your effective rental rate has gone up. The same applies to mortgages. If you plan to pay it out all the way to the end, paying a point or so for a lower rate is probably a good idea. But if your time horizon is shorter, paying points can be expensive.

You can use one of those interest calculators to figure the total interest at the higher, no-point rate. Then figure it at the lower rate and add on the point or points. Remember, a point is 1 percent of the loan amount, or $ 1,500 on a $ 150,000 mortgage.

Related links:

1. Homeowners Taking Advantage of Low Rates to Refinance Loans
2. Money Managing Your Money. The Road to Refinancing
3. It's Time to Refinance; If Stock Prices Rise, Mortgage Rates Will Rise