Should you refinance your mortgage?

30-year fixed-rate mortgages

With 30-year fixed-rate mortgages averaging below 4.25%, and possibly set to rise, should you refinance?

You should at least consider it, Amy Hoak writes in The Wall Street Journal -- if you have the necessary income, credit and home equity.

That is true even if you are a borrower who secured a 5% mortgage rate on a 30-year fixed-rate mortgage last year. Assuming a loan balance of $200,000, if you could refinance into a 4.25% mortgage today, the savings would be about $100 a month. It could take about 3½ years to recoup the costs of the refinance, but those who bought in 2009 presumably would plan on staying in the home long enough for the refi to pay off. 

If you're thinking about it, you need to consider a few things.

Find local rates and home values: Mortgage-interest-rate surveys such as Freddie Mac's give national averages each week, but market and lending factors will cause rates to be higher in some parts of the country and lower in others. Understand what the going rates are for your area.

In general, closing costs will typically be around 1.5% to 2% of the mortgage,, so assume they could add up to $4,000 for a $200,000 loan. Costs also vary by location. It is possible to find a "zero-cost" mortgage, but be aware that you will pay those costs in another way, either with a higher loan amount or a higher interest rate.

The pitfalls in refinancing a mortgage

With mortgage rates at historic lows every homeowner should consider refinancing. However, to make the decision the right way requires more than a rule or thumb or two.

A good bit of advice on the Web suggests the decision is simple: find a rate that is one percent lower than your current rate and you're good to go. Most of these sites are in the business of making loans, and their calculators usually encourage you to go ahead.

A more-sophisticated calculation of the merits of refinancing would include other factors: the borrower's tax rate, inflation expectations, how long the borrower plans to live in the house, the opportunity cost of paying closing costs rather than investing in stocks or bonds, and so on, The Wall Street Journal reports.

There are, to be sure, plenty of websites whose advice is unbiased and sound. The Federal Reserve, for example, offers a refinance resource page on its website that includes a better break-even calculator with tax-rate considerations. 

One obscure calculator comes close. Instead of plugging in today's mortgage rates and determining how long it would take to pay back the closing costs, it uses "optimization theory" to conjure up a person's ideal refinance rate regardless of where rates are now. If you can find a rate that is equal to that rate or lower, it's time to refinance.

The calculator, posted on the National Bureau of Economic Research's website at http://zwicke.nber.org/refinance/index.py, is based on a 2008 paper by two economists at the Federal Reserve and one from Harvard University. Using stochastic calculus, they devised a formula based on the loan size, the homeowner's marginal tax rate, the expected inflation rate over the life of a loan, how long the borrower plans to remain in the house and other factors. 

The Optimal Refinance Calculator spits out tougher numbers than many other calculators in part because it factors in the benefit of waiting beyond the break-even for the chance that rates could fall further. Refinance now and you reduce your ability to refinance later.