Mortgage rates continue to be temptingly low. In fact, the topic of historic low rates is published from major publications every day these days. Now certainly seems like a good time as any to refinance your current mortgage, but before you make an appointment with your lender (that’s if you can get them to return your call these days), take the time to ask yourself the following questions. They will help you determine if refinancing is a good idea or a potential financial disaster.
1. Why do you want to refinance?
There are several goals of refinancing. I originally thought most homeowners considering refinancing are hoping to reduce their overall interest costs, but just as many are happy to do the exact opposite.
Why would anyone do that? It turns out that many borrowers contemplating refinancing are looking to extend their loan for another 30 years to reduce their monthly payment. Yes, their monthly payment is lower (sometimes much lower), but by extending their loan back out to 30 years, the total interests they pay may actually go up.
There’s a third group who would want to refinance – those who bought their homes under an adjustable rate mortgage (ARM). These loans have an initial period of fixed rate interest and then a floating one based on market conditions, so it’s in the borrower’s best interest (no pun intended!) to refinance before that initial rate is set to fluctuate in an effort to manage their costs. By refinancing, an ARM borrower will be able to either change their loan to a fixed rate mortgage or at least extend their initial fixed rate.
These goals are all reasonable reasons to refinance, but there is an endless number of other reasons to refinance. What’s yours? Will the benefit of a lower interest rate loan and (potentially) lowered payments be worth the cost after you factor in closing fees?
2. How long will you stay in the house?
If you might be moving within the next few years, it probably doesn’t make sense to refinance. In my experience in California and high loan amounts, closing costs can be roughly 1% of the loan. I heard it could be even higher with smaller loans, and can be 2% or more of the loan amount.
Let’s say you refinance your $250,000 mortgage and pay 2% in closing cost. That’s $5,000 you have to make up eventually to make the ordeal worth the effort. Even if your monthly payment is reduced by $200, it would take you roughly two years to seemingly make up that upfront cost, and that’s not even calculating how you’ve extended your loan, the time value of money, and everything else that will extend the break even point of your refinance.
If you plan to stay in this home for years, then refinancing will certainly make sense over the long run. If your life may change within the next two years or so though, then hold off on refinancing.
3. How much equity do you have?
If you still owe more than 80% of the home’s value, refinancing might not be the best option for you. Just as with the initial purchase of the home, lenders want to see that you have at least 20% of your home’s value taken care of. If you used up your equity with home equity loans, pay them down before you look into refinancing. Otherwise, you probably won’t get the great rates that made you want to refinance in the first place.
On the other hand, it’s almost a no-brainer to refinance if you put in less than a 20% down payment when you bought the home and you now qualify to take out a mortgage with 20% or more in home equity built up. This could happen because either you paid down the mortgage enough through the years, or more commonly, due to home appreciation. When you borrow with 20% or more in home equity, you can eliminate the private mortgage insurance (PMI) payment. This is a big deal because PMI typically costs between 0.5% or 1% annually, and refinancing with enough home equity can eliminate this fee altogether.
4. How is your credit?
If your credit score took a dive since your original mortgage, refinancing is not a good idea right now. Your dip in credit will affect the rate you can qualify for, making it basically pointless to refinance. You may not even qualify at all, which is worst because you would’ve wasted a ton of time submitting paperwork and also paid for the appraisal and other fees you can never get back.
5. Are you trying to dig yourself out of debt?
For those facing terrible credit card debt or medical bills, refinancing with a cash-out refinance plan — where you borrow more than the amount of your mortgage and take the extra in cash — may seem like the answer to a prayer. Theoretically, you could use the lower-rate money to pay off your high-interest rate bills, and dig yourself out of a money mess.
But this only works for those who are otherwise discipline, have adequate income to service that debt, and just fell on hard times temporarily. Most of the time, people who fall into deep debt tends to continue falling into deeper debt. That’s why taking out a low rate loan to pay for another higher rate loan, even if it’s mathematically a genius move, is often a financial disaster waiting to happen. And even if you refrain from running up your credit cards ever again, you are spreading that obligation to potentially 30 years. The smaller monthly payment is easier to handle, but make no mistake because you still owe the full amount. You thought you did yourself a favor, but you now owe the original amount plus 30 years of interest eventually tacked onto it.
Every day and everyone around you seems to be refinancing these days, so I know it’s tempting to do the same. But before you do anything, know that not everyone will benefit from a refinance application. By answering these five questions, you’ll be better prepared to know if refinancing is the right step for you.
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