Comparison of Refinancing a Mortgage

Identification

Through mortgage refinancing, you take out a new mortgage to pay off your existing home loan. With refinancing, your goal is to effectively lower your mortgage interest rate. For example, you may refinance your current 7 percent, 30-year fixed-rate mortgage into a new 30-year fixed-rate mortgage with a 5 percent interest rate. To reduce interest rate risk, you could also refinance an adjustable-rate mortgage (ARM) into a fixed-rate mortgage. With a fixed-rate mortgage, you can lock in one rate for a set period of time. ARM rates, however, shift periodically alongside the interest rate determined by the Federal Reserve Board. When interest rates rise, your adjustable-rate mortgage payments may no longer be affordable.

You must learn to how to monitor the strength of the economy and the federal funds rate before coordinating plans to refinance. The federal funds rate is a benchmark, or comparison standard, for mortgage interest rates. Banks make overnight loans to each other at the federal funds rate -- so that each bank can meet its Federal Reserve requirements. For their mortgage offerings, banks charge a premium interest rate above the federal funds rate as compensation for taking on increased default risks. In a recession, the Federal Reserve works to lower all interest rates through its federal funds rate and stimulate the economy. At that point, you are more likely to benefit economically from mortgage refinancing. Read "The Wall Street Journal" to follow Federal Reserve policy and its impact on mortgage rates.

The process of mortgage refinancing introduces significant closing costs that may total up to 3 percent of your home principal. According to the Federal Reserve Board, your mortgage refinancing costs will go toward legal fees, home appraisal services, title insurance and loan origination fees. The closing costs help the bank to protect its financial interests as it works to verify that you are a good credit risk and that your home offers sufficient collateral to back the new loan.

You can toggle through an online mortgage calculator to make comparisons and weigh the merits of mortgage refinancing. After using the mortgage calculator, you should be able to determine whether your long-term interest savings will exceed your up-front closing costs on the new loan. As a good rule of thumb, mortgage refinancing will be economical if you can lower your home loan rate by more than 1 percent and plan to own the home for at least the next 10 years.