Should You Refinance Your Home?

EDITOR'S NOTE: This article was originally published in the June 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.

With a drop in mortgage rates, refinancing your home debt might appear to be a no-brainer. And a "refi" could free up some much-needed cash. But first carefully evaluate your refinancing options and consider the impact on your retirement plans.

There's no denying that mortgage rates are attractive. Rates have been hanging out in the low fives, and occasionally in the high fours. For the week ending May 15, the national average rate was 4.99% for 30-year fixed-rate mortgages and 4.68% for 15-year fixed-rate mortgages, according to HSH Associates, a financial publisher. Keith Gumbinger, vice-president of HSH, expects that rates will remain in the fives through the end of the year.

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That's a good thing, because the combination of a refinance boom and bank layoffs means you can't expect a quick turnaround from the bank on your application. If you have the patience, however, the savings could be worth the effort.

Since the credit crunch began, banks have been tightening standards for home loans. You'll need at least 20% equity in the home and a credit score of 720 or higher to qualify for the best rates. Don't expect rock-bottom rates, though, for a jumbo loan (averaging 6.32% for a 30-year fixed loan) or for a loan on investment property.

Be sure to factor in closing costs of about 2% of the loan. You can pay the closing costs upfront or roll them into the loan.

If your rate won't drop by at least a percentage point, refinancing probably isn't worth it. Your biggest decision, though, may be psychological: Can you handle a house payment in retirement? Here are three ways to refinance.

Save now and later. A plain-vanilla refinance, where you dump your old higher-rate mortgage for a lower-rate loan with a similar payoff date, will maximize your savings. If you're 15 years into a 30-year mortgage, compare the remainder to a new 15-year mortgage. Let's say in May 1994, you took out a 30-year mortgage of $300,000 at a 6.5% fixed rate with a monthly payment of $1,896. If your rate drops to 5.5% on the new 15-year fixed-rate mortgage, you'll pay $118 less per month. Over the 15 years, you'll save $21,168 in interest.

You'll need to calculate the break-even point -- the point where your savings will exceed your costs -- to see how long it takes to start saving money. Divide the closing costs by your monthly savings to come up with the number of months it will take to cover the costs. In the example above, assuming $2,000 in closing costs, it will take 17 months to break even. So if you intend to stay in the house beyond a year and a half, refinancing could be worthwhile. Have your lender run the numbers, or use an online refinancing calculator, such as HSH.com's "Refinancing Worksheet."

Owners who want to pay off the house by retirement could benefit from shortening the term of the new loan. If the homeowner above refinanced the $300,000 mortgage into a ten-year mortgage, instead of a 15-year loan, he would pay $466 a month more. But in the long run, he would save $57,832 in interest.

Save more money now. You can also save money each month by, say, trading in your old 30-year mortgage for a new 30-year mortgage. You could use the freed-up cash to rebuild your decimated nest egg. Lowering the monthly payment by extending the term could make sense for a retiree who has a monthly shortfall and needs money now to pay expenses, says David Lamp, a financial planner at BBJS Financial Advisors, in Seattle.

If you remain in the house until you pay off the new 30-year mortgage, you'll pay more interest in the long run. Using the $300,000 mortgage at 6.5% originated in 1994, the homeowner has already paid $258,994 in interest. If the owner stays with his original mortgage for the remaining 15 years, he'll pay another $123,639 in interest. If he trades in the old 30-year loan for a new 30-year mortgage at 5.5%, he will drop his monthly payment by $660. But he will pay $227,264 in interest over the life of the new loan -- nearly $104,000 more in interest than if he kept the original loan.

Pulling out equity. Many financial advisers say that locking up a lot of money in a house is often not financially wise. However, leveraging the house to pull out some cash has a risk. If you psychologically can't handle upping your mortgage debt, don't do it.

But owners who have sizable equity and are comfortable with pulling out some of it might consider a cash-out refinance. Say you owe $100,000 on your house but it's worth $700,000. You could take out a new mortgage for $300,000, pay off your original mortgage and take $200,000 in cash.

You can invest that $200,000 elsewhere, which can help you diversify your overall asset portfolio, says Jay Hutchins, a financial planner with Comprehensive Planning Associates, in Lebanon, N.H. To come out ahead, the return needs to beat the cost of financing. Most advisers suggest conservative investments, such as short-term bonds. This gives you some flexibility to wipe out the mortgage if you choose.

A cash-out strategy also helps you if prices rise in the future. "A fixed-rate mortgage is a good inflation hedge," says Jane Young, a financial planner at Pinnacle Financial Concepts, in Colorado Springs, Colo. When inflation rises, the dollars you use to make your mortgage payment are cheaper and the money you have invested would benefit from higher interest rates and higher prices.

But these days, many lenders aren't eager to do cash-out refinancing. With home prices still in decline, it's hard for banks to know how much risk they're taking on. Homeowners "will face higher rates and higher fees," says Gumbinger.

Also, if you don't plan to invest the pulled-out cash, consider how you intend to spend it. If you're making home improvements, a cash-out refi could make sense. If you're planning to buy a fancier car, think twice. Enhancing your lifestyle will increase your debt while putting your house at risk. "You don't want to support bad spending habits with the house," says Young.

Before locking into terms on a refi, shop around. If your original lender still holds your loan, you might get a break on closing costs. Get three or four quotes.

Homeowners with adjustable-rate mortgages have a particularly hard decision to make. A year ago, ARM holders were concerned about their mortgages resetting to higher rates. Now ARM rates are in the threes. ARM owners may be reluctant to lock into the fives for a fixed mortgage.

Gumbinger warns, though, that these low rates could be temporary. "Keep in mind that with rates historically low, there's only one direction to go in the future," he says. You may want to enjoy the dip now, but lock in a fixed rate in a few months.

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