With interest rates remaining at all-time lows, home owners are often tempted by stories of reduced interest payments, more favorable loan terms and the ability to obtain thousands of dollars in cash from the equity in their homes. But refinancing your mortgage might not be a good idea. Home owners considering refinancing should first take a look at the pros and cons.
Closing Costs Vs. Monthly Savings
A lower monthly mortgage payment is an attractive option because it can save you money over the long term. However, a refinance loan requires the borrower to pay closing costs. In some cases, closing costs can be so high that the borrower's monthly savings over the term of the loan might only break even with the costs of refinancing. Or the monthly savings could be less than what was put forth in closing costs which actually causes you to lose money over time.
The chances of you breaking even or losing money on a refinancing are higher if you don't plan to stay in your home longer than a few years, according to Investopedia. You can calculate your break-even point by multiplying your monthly savings by the number of months you plan to remain in your home. Subtract this total from your closing costs to calculate your total savings.
Length Of Loan Term
While refinancing a mortgage loan into a longer term can lower monthly payments, changing from a 20-year to a 30-year loan can actually cost more money over the course of the loan. Why? Borrowers often end up paying more in interest charges over the extended life of the loan, outweighing any monthly savings.
Adjustable Vs. Fixed-Rate Mortgage
Adjustable-rate mortgages are mortgages that have an interest rate that fluctuates based on a rate index. They are attractive to borrows that expect interest rates to fall because this causes a corresponding decrease in the mortgage interest payment. However, adjustable-rate mortgages expose borrowers to increased risk as interest rates rise, subjecting them to rising monthly interest payments.
With a fixed-rate loan, a borrower's monthly payments will never fluctuate based on changing market rates. If you are averse to the possibility of having to pay higher interest on your mortgage, then you should not refinance your fixed rate mortgage into an adjustable rate mortgage.
Remaining Loan Balance
Borrowers already halfway or more through the term of their mortgage loans won't save by refinancing, according to CreditFYI.com. That's because these borrowers have already paid down a good portion of the loan interest, and refinancing means they'll be essentially starting over in terms of paying off interest. If mortgage payments have reached the point where most of the monthly payment is going straight to the principal balance, refinancing may not make sense.
On the other hand, borrowers who have been paying off their home loans for just a few years are likely to have payments that are mostly going to paying off interest. Refinancing at this stage can sometimes do little more than increase the total amount of interest the borrower pays over the term of the loan.
Remaining Home Equity
Borrowers with 20 percent or less equity in their homes should steer clear of refinancing. When the 80 percent threshold is reached (meaning that the mortgage loan is equal to or greater than 80% of the value of the home), borrowers must pay for private mortgage insurance (PMI) which can drastically increase monthly payments. Borrowers below the 80 percent threshold choosing to refinance for a lower interest rate can safely do so provided they don't take equity from the home in the form of cash.
Experts have mixed opinions on using home equity and refinance loans to reduce short-term debt. While some borrowers have enough equity in their homes to pay off credit card and other debt, some financial experts say it's not wise to transform short-term (credit card, auto loans) debt into long-term mortgage debt. If consolidating your debt by refinancing your mortgage won't improve your financial situation, it's best to avoid this strategy.
Most borrowers don't know enough about mortgage loans to make an informed decision when it comes to refinancing a home mortgage. Every borrower has a distinct set of circumstances that must be carefully considered before making a decision. It's always wise to discuss your refinancing options with a trusted financial advisor who can provide an accurate picture of the costs and savings breakdowns.