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Mortgage Refinance

When Does it Make sense to Refinance a Mortgage?

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Looking to refinance your mortgage? Now is probably a good time to check your credit. Your credit score will affect your ability to get the best rate on your mortgage. "It usually takes at least a 1 percent drop in your interest rate to justify the cost of refinancing. If you aren't paying yourself back for the cost of refinancing in two years," says Guy Cecala, publisher of Inside Mortgage Finance, a weekly newsletter based in Bethesda, Md., "it's probably not worth it." click here to calculate if your pay back will be two years or less.

For example, if it costs $3,000 to refinance your mortgage and your monthly mortgage payment drops by $100 a month, the payback period would be 30 months ($3,000 divided by $100). That's too long according to Cecala's guidelines.

And make certain your savings are what you think they are. While your cash flow in the example above may increase by $100 a month, your real savings should be computed after taxes.

Remember, a lower interest rate on your mortgage often means you have less interest to deduct come tax time. If you have a 15 percent effective tax rate, and your refinance reduces your mortgage interest by $1,200 in the first year, your income-tax bill would increase by $180.

That means you will really only save $85 a month after taxes. Do the math again. Take $3,000 divided by $85 - and the payback period is 33.3 months.

Since taxes are such an important part of the payback calculation, consider the effect any tax-cut proposal might have. John McGowan, chairman of the accounting department at St. Louis University, notes "the impact of any income-tax reduction will also reduce the value of mortgage interest as a tax deduction."

For example, if you currently pay $10,000 a year in interest on your mortgage, and your effective tax rate were decreased by 3 percent, your mortgage interest deduction would provide $300 less of a tax benefit after the tax cut.

Regardless of the tax effect, one way to reduce the payback period is find a loan with reduced costs. Mr. McGowan points out some mortgage companies may refinance loans without closing costs. "In this model, it would always be desirable to refinance at any lower rate, since you'd break even immediately."

Rich and Debbie Petrosh found a deal in which mortgage refinancing fees were included in the new mortgage. From the first payment they were saving about $130 per month.

"Refinancing at this point is a no-lose," says Mrs. Petrosh

Still on the fence? You might consider some alternatives to refinancing your mortgage

If your objective is to pay off your mortgage early and save interest, you can pay an extra $100 a month and pay off a typical 30-year mortgage in about 22 years. But first check with your lender to be sure your loan does not have a prepayment penalty.

Many adjustable-rate loans have a "conversion" clause that allows the borrower to convert to a fixed-rate loan by paying a small fee. You can also ask your lender about a rate >modification.

Consider a home-equity loan to consolidate debt or make home repairs. Most mortgage lenders charge no closing costs on home equity loans. You will pay a higher interest rate and the maximum loan term is usually less than 20 years.

If your objective is to pay off your mortgage early and save interest, you can pay an extra $100 a month and pay off a typical 30-year mortgage in about 22 years. But first check with your lender to be sure your loan does not have a prepayment penalty.

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