Dear Dr. Don,
I am having trouble deciding whether to refinance at today's low interest rates.The decision seems easy until I factor in all the costs to refinance. I am in a seven-year interest-only adjustable-rate mortgage, or ARM, that is going to have its first rate adjustment next year. The current interest is 5.875%. I can refinance into 3.75% for a 30-year loan, or I can pay a quarter point to reduce that interest rate to 3.50%.

When estimating the refinancing costs, they're totaling about $4,576 with no points, or $5,618 with the points. This does not include the mortgage prepayments that I have to make, escrow taxes, and the amount I have to pay down to reduce the loan to the conforming limit of $417,000.

I realize a major factor is how long will I stay in the apartment I own. I just don't know. It will probably be another two or three years, maybe even five years. I may even decide to keep it as an investment property after I move out.

Thanks,
-- Susan Scenario

Dear Susan,
You've got too many moving parts for the typical refinancing calculator. Doing a cash-in refinancing so you have a conforming loan at $417,000 that won't draw a higher, jumbo loan interest rate is an easy enough decision. That cash is probably earning very little as savings (though you want to make sure you'll still have some cash saved in an emergency fund). But what's hard to measure is how much you'll save on mortgage interest because your adjustable-rate mortgage resets next year.

In your case, the two key reasons to refinance are: if the loan becomes fully amortized next year and you can't afford the higher mortgage payments that will include principal as well as interest; or, if you're planning to own the apartment for a long time and you want to lock in today's low interest rates by refinancing with a conventional fixed-rate mortgage.

I'd normally say that if you're not sure how long you're going to be in the apartment, then paying discount points to reduce the interest rate on your mortgage isn't likely to make sense. But if you can pay just a quarter point in discount points to reduce the interest rate by 0.25%, that's a bargain and you should do it if you do decide to refinance.

It's common to look at the break-even point in a mortgage refinancing as how long it takes you to recoup your closing costs from the resulting lower monthly mortgage payment, but that's not the right way to look at it. You're trying to reduce your total interest expense. The break-even point is when you've covered your closing costs through reduced interest expense. Paying discount points is part of your interest expense and has to be considered in the decision.

You should also take a look at the loan documents for your existing loan and estimate the new mortgage rate when your ARM adjusts. With rates going down, you may realize substantial interest rate savings without refinancing, though your loan is likely to convert from interest-only to a fully amortized loan over the remaining 23-year loan term. That will substantially increase your monthly mortgage payment.

You could also consider refinancing your 7/1 ARM with a new 7/1 ARM. Bankrate's national average for a 7/1 adjustable-rate mortgage is, as I write this, 3.03%. That would give you another seven years of certainty concerning the mortgage interest rate, and save you almost 0.5% off of the 3.50 refinance rate.

If you don't expect to be in your home for long, then you should be able to take on the interest rate risk associated with the annual rate resets that will begin on your current 7/1 ARM. If you plan to own the home indefinitely, then a refinance into conventional financing at today's low rates makes sense.

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