Refinancing in a rising-rate/rising-property-value market

With interest rates no longer at rock-bottom levels, few borrowers still have an opportunity to profit by refinancing into a lower interest rate. However, the escalation of house prices in many areas raises the possibility of profitable refinances directed to lowering other costs.

Borrowers who purchased mortgage insurance when they took out their current mortgage may now have enough equity in their house that they can refinance into a mortgage that will not require mortgage insurance.

Similarly, borrowers who took out a pricey second mortgage in order to avoid mortgage insurance can refinance into a larger first mortgage.

Borrowers with substantial amounts of high-interest, short-term debt may now have enough equity to pay it off with proceeds from a cash-out refinance.

This article is limited to refinancing designed to eliminate mortgage insurance.

It pays if the monthly premiums that are eliminated exceed the cost of refinancing plus the higher interest cost of the new mortgage over its future life. In making this comparison, the monthly premiums that are eliminated should be measured over the period until insurance on the existing mortgage is terminated. When that can happen depends on the termination rules to which the mortgage is subject. There are two sets of rules.

Federal rules applicable to all home mortgages: Borrowers can request their lender to terminate their insurance when their loan balance reaches 80 percent of the original property value - the value when the loan was originated. For example, a 30-year fixed-rate loan at 3.5 percent that was 95 percent of property value at origination will hit the 80 percent mark in 88 months. If the mortgage is now four years old, the savings from refinancing it would consist of the premiums over 40 months (88 minus 48). The older the loan, the smaller the potential saving.

If the borrower fails to request termination at 80 percent, the insurance will terminate automatically at 78 percent, or 10 months later. The maximum possible saving in that case would be 50 months of premiums.

Fannie Mae/Freddie Mac rules: If the loan was originated under Fannie Mae or Freddie Mac guidelines, termination is based on current appraised value rather than original value. The minimum period is two years if the current loan-to-value ratio is 75 percent or less; five years if the ratio is 80 percent or less. The borrower must request termination and pay for an appraisal.

If the house has appreciated in value, these rules allow mortgage insurance to be terminated earlier than the general rule, reducing the potential benefit from refinancing. For example, if the home referred to above appreciates by 4 percent a year, the loan balance will hit 80 percent of current value after only 35 months rather than 88 months. Since the loan is four years old, the insurance should already have been terminated.

In sum, the savings in insurance premiums from refinancing Fannie/Freddie loans is small, and especially so in areas that have experienced marked house price increases. Of course, there is the proviso that borrowers exercise their right to have the insurance terminated. Some don't do it because of the hassle and the appraisal cost, but getting rid of the insurance by refinancing is much more of a hassle and the costs are much higher.

The cost to which the saving in insurance premiums should be compared consists of upfront origination costs and higher interest cost over the future life of the new mortgage. The interest cost depends not only on the difference between the rate on the old and the new mortgage, but also on how long the new mortgage will be in force. For most borrowers, this is a guess with a large margin of error.

The first priority for borrowers paying for mortgage insurance is to determine whether they can get it terminated. If they can't, they can use my calculator 3a to see if they will benefit from refinancing. They can find the origination costs and interest rate on a new mortgage, which the calculator needs, by going to the "Shop Your Loan" page on my site.

Next week, I will look at the prospects for a profitable refinance aimed at eliminating a high-cost second mortgage.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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