Crunch the numbers: With higher interest rates, refinancing is a challenge

Question: We took out a home equity line of credit a couple of years ago and thought we were getting a great deal with an interest rate set to the prime rate. At that time, prime was only 4 percent, so the money was very cheap. Now, it has almost doubled to 7 percent, and so have our monthly payments. At this point, we are thinking it might be smart to refinance our first mortgage to pay off the $65,000 balance on our home equity line with a new fixed-rate mortgage. Would that make sense? – Q.W., Lynnwood

Answer: You are in a situation similar to many people who purchased homes or refinanced their mortgage in 2004. By June of that year, the Federal Reserve had lowered interest rates to historic lows. The benchmark Federal Funds rate had fallen to only 1 percent, a 46-year low. And as you pointed out, the prime rate – which is the rate that banks typically charge to their best customers for credit cards and loans – was down to only 4 percent.

Everyone was happy, because money was very inexpensive.

Then the Federal Reserve began to worry that the improving economy would turn into a boom and all the easy money would cause inflation. So the Fed began a slow, steady process of raising the federal funds rate – which is the rate that banks charge each other for overnight loans – nearly every month for the past 18 months.

Today, the fed rate is 4.25 percent – a 325 percent increase. And the prime rate has increased more than 81 percent to 7.25 percent today.

The good news is that the Federal Reserve’s relentless rate hikes have had the desired effect of keeping inflation low, which has in turn kept mortgage rates from rising as dramatically as short-term interest rates. While the prime has risen 81 percent since summer 2004, mortgage rates have risen only about 20 percent since then.

The average 30-year fixed mortgage rate was about 5 percent without paying any points in mid-2004, and the rate is about 6 percent without paying any points today. So, compared with all the other interest rates, mortgage rates are still very affordable.

Another piece of good news is that thanks to the booming housing market across the country, Fannie Mae raised the maximum loan amount for conventional loans to $417,000 at the end of this year, compared with $333,700 in 2004.

In simple terms, that means you can now borrow $84,000 more at the lowest possible mortgage rates than you could last year. In 2004, if you wanted to borrow $400,000 to purchase a home or refinance your mortgage you had to get a $333,700 first mortgage and a $66,300 second mortgage or home equity line of credit. Now, you can borrow the whole $400,000 – plus closing costs – and still get a low interest rate 30-year fixed rate mortgage.

Whether this makes sense depends on a couple of factors: What is the rate of your current first mortgage? If you got a 5 percent 30-year, fixed-rate loan in 2004, you may not want to refinance into a new mortgage at today’s rates.

Also, what is the amount of your second mortgage (or home equity line of credit) in relation to your first mortgage? The larger the second mortgage, the more sense it might make to refinance into a new first mortgage.

Here’s a specific example: Let’s assume you borrowed $400,000 on a first and second mortgage combination as described above. If you had a $333,700 30-year, fixed-rate loan at 5 percent interest, the payment would be $1,791.37 a month. And if you have a $65,0000 balance remaining on your home equity line of credit, at 7.25 percent interest, your payment would be $593.36 a month. So the total combined payments of the first and second mortgage loans would be $2,384.73 a month.

Then, if you refinance with a new $400,000 30-year, fixed-rate loan at 6 percent interest, your payment would be $2,398.20 a month. So there would not be an advantage to refinancing, unless you are afraid the prime rate will continue to rise.

If your first mortgage rate is higher than 5 percent, or if you have a smaller first mortgage and a bigger second mortgage, the numbers might make sense for a refinance. Each case is different, so you need to crunch the numbers yourself or find a good mortgage loan officer to do it for you.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com