by Archie M. Richards, Jr., CFP^®
August 19, 2002

Here are a few pointers about mortgages and refinancing:

1. Obtain a mortgage that goes out as long as possible and don't pay it off early. Acquire investments instead.

   Here's why. Low interest rates make borrowing inexpensive. And with stock prices at low levels, the prospects for the market are terrific. Be sure to diversify widely among different types of securities. You can arrange for mutual funds to withdraw money from your bank account every month. Investing can be just as automatic as mortgage payments.

2. "Equity" is the portion of your home you own free and clear. If the house is worth $100,000, for example, and the mortgage is $80,000, the difference of $20,000 is your equity.

   If your equity is less than 20 percent of the value, the bank probably insists that the premium for "private mortgage insurance" (PMI) be included in your monthly mortgage payments. Should you default on the mortgage, it would be paid off by the insurance company, making the bank whole.

   But if your equity is greater than 20 percent of the value of the home, ask the bank to omit the private mortgage insurance. This saves your paying the premium and cuts your monthly payments.

3. Closing costs include appraisal fees, attorney fees, and other miscellaneous charges. You should refinance only if the new mortgage payments are less than they are on your current mortgage, despite paying the closing costs during the time you expect to own your home.

   You think you'll own the home for 5 years. That's 60 months. Let's say the new mortgage is $100,000 for 30 years. The interest rate is 6 percent. Your payments on the loan are $600 a month. The closing costs are $2,000.

   Pay the closing costs in 60 months. This amounts to $33 a month ($2,000 divided by 60).

   During the first 5 years, your monthly payments are $633 per month ($600 plus $33). If this is less than you're paying now, go ahead and refinance. (If you still own your home after 5 years, your payments can fall to $600.)

   If the $633 total is not less than you're paying now, wait for interest rates to drop further.

4. "Points" are payments the bank receives up front for making the loan. If you're borrowing $100,000 and the bank charges 2 points, the bank receives $2,000. The points are usually added to the loan balance, meaning that you actually borrow $102,000.

   Banks generally offer a choice of loans. You're better off with higher points and lower interest rates.

   For example, at the time of this writing, Quicken Loans (800-784-2536) offers a loan with interest of only 1.875 percent plus 6½ points. (You'll find no mention of this on www.quickenloans.com The company offers many loans not shown on its website.)

   Instead of $100,000, the amount of the loan would be $106,500. For a 30-year loan, monthly payments would come to $387.

   This is an "adjustable rate" mortgage (ARM). The interest rate can be adjusted up or down every year. If interest rates in the economy rise, the rate can go up, but no more than 2 points per year.

   The rate on this loan can never exceed 6.875 percent. This is called the "lifetime cap."

   In the long run, I expect interest rates to go down, not up. But even if rates rise in the meantime and hit the lifetime cap, 6.875 percent isn't all that bad. I think the stock market will rise faster than that in the long term.

   If interest rates do fall, the rate on this loan will decline as well. The loan would refinance automatically.

   Let's look at an alternative loan that has a higher interest rate and no points. You could currently obtain a one-year adjustable rate mortgage with interest of 5 percent and no points. For a thirty year mortgage, the payments would be $537.

   $537 is a lot higher than the $387 payments on the loan with the low interest and 6½ points mentioned above.

   Mortgage interest rates count for more than points.