Should You Refinance?

provided by

Yes -- if you plan to stay awhile. But even lower mortgage payments can cost you in the long run.

Waves of homeowners are rushing to refinance their mortgages. And no wonder: Long-term rates have collapsed to historic lows.

Thirty-year home loans can run as cheap as 5% right now -- down from 6.4% as recently as last summer.

By any long-term measure, today's rates are a great deal.

The refinancing boom means a sudden surge in new business for a lot of mortgage brokers. The typical refi costs a homeowner maybe $2,000 or so in costs, including fees.

Brokers may be among the few making out in this economy -- which is ironic, because some (repeat: some) are the villains who got us into this mess in the first place.

But before you join the stampede, it's worth asking: When does it make sense to refi?

If you are planning to move or even pay off your loan within the next few years, refinancing probably makes little sense because you won't be paying monthly bills long enough for the savings to cover the costs.

On the other hand, in some circumstances, refinancing is pretty much a slam dunk.

If you plan to stay in your home for years, and you are currently in an adjustable-rate mortgage, you should strongly consider a refi. ARMs are incredibly dangerous -- the financial equivalent of Russian roulette, but with multiple bullets. Refinancing into a 30-year fixed-rate loan may not cut your current monthly payments by much, but it gets rid of the risk that those payments will suddenly skyrocket.

Refinancing also usually makes sense if you are currently paying a much higher rate, though few homeowners are any more.

As a rule of thumb, Greg McBride, economist at Bankrate.com, looks for a payback period of a couple of years. "Generally, if you can earn the costs back within two to three years, and it's a home you're prepared to stay in for much longer than that, it's usually a good thing," he says.

But if the savings are more marginal, you need to do the math.

Some mortgage brokers will tell you how much interest you will save "over the life of the loan" if you refinance.

It's usually a very large number. But it should also be taken with a grain of salt.

First, that number ignores taxes. Mortgage interest is deductible from your income tax. So paying less interest may mean you will pay slightly higher taxes.

What that actually does to your monthly savings is more complex, because your mortgage bill includes principal repayment as well as interest, and only the interest is deductible. Interest shrinks as a proportion of the bill over time. But you could certainly shave maybe 25% off the overall savings as a very crude starting point to see a more realistic number.

The second problem? The total savings figure also ignores the time value of money.

Thanks to inflation, those dollars are going to be worth a lot less by the time you get hold of them than they would be today. Even if inflation only averages 2.5% a year, which is incredibly optimistic, a dollar in 30 years' time will only be worth 50 cents in today's money.

And that's not all. That figure also ignores the magic of compound interest.

Refinancing costs money. And that money, if you invested it instead of spending it on refinancing fees, could earn you a very good return. Especially over a long time period -- like 30 years.

Imagine your refinancing costs would be a fairly typical $2,000. If you socked that money away at just 5%, by 2039 you'd have $8,600.

And that's a paltry long-term return.

The collapse in the stock market makes this more compelling, not less. At today's distressed levels, anyone investing over 30 years has an excellent chance of producing terrific returns. If you can earn 9%, then that $2,000 would grow to a thumping $26,500.

Food for thought.

Write to Brett Arends at brett.arends@wsj.com