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TO REFINANCE OR NOT TO REFINANCE Tempting low rates not the only factor worth considering

THE BALTIMORE SUN

When Frank and Kathleen Meeder saw interest rates dropping to new lows early this month, they acted fast. Working with a lending agent at Loyola Federal Savings and Loan Association, they refinanced, and switched from their three-year adjustable-rate mortgage at 9 5/8 percent (and with a 30-year term) to a 30-year, fixed-rate loan at 8 7/8 percent.

Thanks to their action, the Meeders are now paying about $175 less in principal and interest each month for their four-bedroom Colonial in Towson. They're also free from worries about shifting interest rates.

"Our feeling is that with the economy going up and down, it's good to lock into something that you feel is reasonable," said Mr. Meeder, a manager at C&P; Telephone. "It's better to have a sure thing than to have to revisit your loan every three years."

The Meeders are far from alone. Ever since the Federal Reserve Board lowered its discount rate to 5 percent in mid-September, driving mortgage rates down to their lowest levels in at least four years, hordes of homeowners have poured into banks and other lending institutions to refinance.

Many lending institutions say that refinancing applications have increased substantially since 30-year fixed rates fell to about 8 1/2 percent, and three-year ARMS fell to about 7 percent. At Loyola Federal, such applications now make up about 35 percent of the total volume of applications -- a jump of at least 15 percentage points from earlier this year, according to Peggy Rhodes, vice president of the savings and loan. Ms. Rhodes noted that the current volume matches that of January and February, when interest rates also dipped.

Like the Meeders, many people are switching from ARMs to fixed-rate mortgages -- a decision that can make a lot of sense, lending agents say. "If you're planning to stay in your house for any length of time, an ARM right now isn't strategic, since it's so close to the fixed rate," said Gene Lugat, chairman of the Greater Baltimore Board of Realtors' Mortgage Finance Committee and vice president of PaineWebber Mortgage Finance Inc. "It's probably a good time to lock into a fixed rate."

Another popular option: switching from a 30-year to a 15-year loan. When Stephen and Sheila Rochfort of Parkville refinanced their 30-year ARM loan at 9 percent in mid-September, they exchanged it for a 15-year fixed-rate loan at 8 3/8 percent. Their monthly mortgage payments increased, to $1,197 from $995. But the peace of mind afforded by a fixed-rate mortgage, as well as the knowledge that they'll be paying off the loan sooner, compensates for the added pressure on their wallets.

"I always felt that if I could get to the point where I could convert to a 15-year mortgage, I should do that," said Mr. Rochfort, a project manager at Westinghouse Electronic Systems Group. "And rates got to a point where it became possible."

Although halving the term of your loan may increase your monthly payments, it's still a good idea if you can afford it, said Chip Reichhart, executive vice president of Maryland National Mortgage Corp. You'll be paying less interest and will build equity faster, he noted.

Another emerging trend is the tendency to diverge from the old "2-2-2" rule, which states that you should not refinance unless you've been in your home for two years, your interest rate is at least two points over the current rate, and you plan to remain in your house for at least two more years. Some lending agents, pointing out that settlement costs usually amount to 1 percent of the loan plus points, still subscribe to that theory.

But others say that it can be wise to refinance even if the interest rate differs only by 1 percent or 1.5 percent. That's particularly true if you have a large balance remaining on your loan, over $100,000, and you're planning to remain in your home for at least three years.

"In most cases where you see a drop in the rate of 1 percent to 2 percent, it will only take you three or four years to recover closing cost expenses]," said Mr. Reichhart. "If your loan balance is significant enough, it may make sense [to refinance]."

To determine whether refinancing is a good option for you, calculate how long it will take you to recover the closing costs accumulated by taking on the new loan, suggested Mr. Reichhart. First, add the costs of refinancing, which generally includes points and appraisal fees. Then calculate the difference between your projected monthly payments and your current payment. Divide the costs of refinancing by the monthly savings to determine the number of months it will take you to recover the costs of the loan.

If the number you arrive at is five or six years, and you only plan to be in your home for another two years, it might not be worth it.

Quick calculations

Determining whether refinancing at a shorter term will put you ahead is a bit more complicated.

It involves calculating the monthly interest expense on the 15-year loan and comparing it to the interest expense on the 30-year loan. To obtain the interest expense on the 15-year loan, multiply the loan amount by the interest rate, and divide that sum by 12.

Subtract the result from the interest expense on the 30-year loan. Divide the final sum into the settlement costs, and you should have a rough idea of the number of months it will take to pay off the closing costs, according to Dick Loeffler, director for product development at First Advantage Mortgage Corp., a subsidiary of First American BankShares Inc.

For example, if your current mortgage is $100,000 at 10.5 percent, you're paying about $875 each month toward interest ($100,000 x .105 divided by 12). For a 15-year loan of $103,000 at 8 1/8 percent, you'd be paying $697.40 toward interest each month. The difference, $177.60, divided into the estimated closing costs of $3,000, is about 17 months. (These figures don't take into account the amortization of the loan).

"Your actual out-of-pocket expenses will be more with the 15-year loan, but the actual interest expense will be significantly less," said Mr. Loeffler.

All of these calculations might be unnecessary if you're considering a "zero cost" refinancing loan. In these programs, now being offered by lending institutions, the lender pays all of the closing costs, including the points. Generally, the interest rates are slightly higher, but your length of stay in the house is no longer a concern.

You may be required to pay some costs, to cover an appraisal or credit report, for example. But your money is refunded at closing, according to Charles Reid, director of production for First Advantage Mortgage Corp.

There's another advantage to the zero-cost program: You don't have to worry about interest rates dropping after you've taken out the new loan. "Typically when you refinance, you're paying costs, and you say, 'I'll have to wait till rates really go down again until I can do it again,' " said Mr. Reid, whose company offers several zero-cost programs.

"But this way, you can refinance again if they go down even a little bit, because you don't have to pay the closing costs."

The seven-year balloon, which begins at one interest rate and switches to another after seven years, is also gaining popularity, said Peggy Rhodes of Loyola Federal.

Typically, the initial interest rate is about 1/2 percent lower than the 30-year, fixed-rate quote. Depending on the program, you may have the opportunity to refinance after seven years, or the loan may roll into a fixed rate. The rates usually are tied to a well-publicized measure, such as one used by the Federal National Mortgage Association, which buys and resells mortgages.

Your income taxes are yet another factor to consider when you're refinancing, particularly if you have a number of personal or credit-card loans on which you cannot deduct interest.

Since you can deduct interest on your mortgage, it might be a smart move to borrow beyond your original balance and use the extra cash to consolidate and pay off your debts, according to Douglas Harrington, a tax manager at Coopers & Lybrand, a national accounting firm. Just make sure that your total home-equity debt doesn't exceed $100,000, because that's the point at which the tax law says you can no longer deduct the interest.

Also, be aware that such a mortgage cannot exceed 75 percent of the appraised value of your property. (On a standard refinancing deal, which covers your mortgage balance plus costs, the new mortgage cannot exceed 90 percent of your home's value.)

Another tax angle to chew on: Any points you pay in a refinancing must be spread out and deducted over the length of the loan, according to Mr. Harrington.

Nearly all lending agents agree that no matter why or how you're planning to refinance, now is the time to act.

"Rates could get a little bit lower, but what happens if they go back up?" said Chip Reichhart, noting that 8.5 percent for a 30-year fixed-rate loan is "really the best rate we've had since 1978 or 1979 on a sustained basis."

Is it for you?

Still, refinancing isn't for everyone.

Stanley and Nancy Lang of Ellicott City considered refinancing their $170,000 ARM loan when they saw interest rates slide. But once they saw what the process involved, they decided to follow another route: locking into a fixed rate, an option permitted them every three years on their ARM. Within the next few weeks, they expect to obtain a loan with a 9.3 percent interest rate, a nice drop from 10 7/8 percent, their previous rate.

"We could have gotten a cheaper rate, but it wasn't worth paying all the points and the closing costs," said Mr. Lang, owner of a building restoration business.

Indeed, refinancing can bring up some unexpected hassles. According to Peggy Rhodes, it's not uncommon for homeowners to be disappointed in the appraisal of their homes. "We always think our homes are worth more perhaps than an appraiser does," said Ms. Rhodes.

But getting an appraisal done before you've applied for the new loan isn't necessarily a good solution, either. The Financial Institutions Reform, Recovery and Enforcement Act sets strict guidelines about appraisals, said Ms. Rhodes. Your lender may not be able to accept the appraisal that you have conducted independently.

You should also be aware that if you don't reduce the term of your loan when refinancing, you'll be extending the mortgage's length, and ultimately paying more interest on it.

If, for example, you refinance to a 30-year loan after having lived in your house for 10 years -- thus having only 20 years left on your original mortgage -- you'll be lengthening the loan again to 30 years, and returning to the original proportions of principal vs. interest.

If you're not planning to stay in the house until you pay off the loan, or if your main purpose is to reduce your total cash outlay, such factors may not concern you. Mr. Lugat recommends contacting a lender to help you weigh different options.

Alyssa Gabbay is a free-lance writer who often covers business issues for The Sun.

Options to refinance

Options for refinancing $100,000, 30-year fixed-rate mortgage nTC at 10.5 percent (original principal and interest payments at $914.73).

Option 1: 30-year fixed-rate mortgage at 8.5 percent, with two points and closing costs ($3,000) rolled into loan.

Principal and interest: $791.98.

Number of months to recover settlement costs: 24.4.

Option 2: 30-year fixed-rate mortgage at 9.5 percent, with no closing costs or points.

Principal and interest: $840.85.

Number of months to recover settlement costs: 0.

Option 3: 15-year fixed-rate mortgage at 8.125 percent, with two points and closing costs ($3,000) rolled into loan.

Principal and interest: $991.77.

Number of months to recover settlement costs: 17 months.

Option 4: 3-year adjustable-rate mortgage at 7 percent, with two points and closing costs ($3,000) rolled into loan, and 6 percent lifetime cap.

Principal and interest for first three years: $685.26.

Principal and interest at highest rate possible: $1,139.39.

Number of months to recover settlement cost: 13.

Option 5: 7-year balloon 7 7/8 percent, with two points and closing costs ($3,000) rolled into loan.

Principal and interest for first seven years: $746.82.

Number of months to recover settlement costs: 17.86 months

SOURCE: Dick Loeffler, First Advantage

Case histories

With its lures of lower monthly payments, refinancing can seem like an enticing option. But unless you're planning to obtain a loan with no closing costs and points, it's usually wise to recast your mortgage only if you're planning to stay in your

house for at least two or more years.

To illustrate, let's look at the cases of Family A and Family B. Both families have $100,000, 30-year fixed-rate mortgages at 10.5 percent, and both are paying approximately $915 per month in principal and interest. Each family is considering a 30-year fixed-rate mortgage at 8.5 percent, which, if we calculate in $3,000 worth of closing costs and points, would reduce their monthly payment by about $123.

Refinancing is a good move for Family A, which plans to remain in its home for five more years. But it's not for Family B, which is intending to sell its house in a year.

Here's why: At the end of 10 years, Family A will have paid off the closing costs of about $3,000 and will have benefited from the lower payments to the tune of $4,380. That's $123 multiplied by 60 months, minus $3,000 in closing costs. (The family will, however, be extending the term of the loan).

Family B, on the other hand, will not have recovered the closing costs by the end of the year (the time to regain the costs would be about 24.4 months), and will actually have lost about $1,524. We can arrive at that number by multiplying $123 by 12, and subtracting that sum from $3,000.

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