Every year, thousands of people turn to their existing assets to aid them in hard financial times. Refinancing allows you to renegotiate your debt obligation under different rules, therefore freeing up cash or breaking your debt into more manageable amounts. However, there are reasons to refinance even when you are not going through a financial struggle. First, let's take a look at the top reasons to refinance.
- To consolidate debts: Many people choose to take out a second mortgage on their home or refinance their car to escape high-interest credit card bills. This allows you to pay the interest on the mortgage instead of the interest on the card, which is generally much lower. It also gives you fewer bills to worry about and payments to make. Instead of filing through several credit card payments, you just pay the second mortgage. As a bonus, the interest is often tax deductible, allowing you to save even more. If you find yourself with several insurmountable credit card bills, and if you routinely fall behind and find yourself riddled with late fees, this may be a good option.
- To reduce the length of your original loan: If you feel ready to possibly take on slightly higher payments, you can refinance for a shorter term. This could end up saving you thousands of dollars on interest, and also get your obligation out of the way more quickly. Alternatively, if your payments are piling up, you can extend your term to reduce your monthly payment right away.
- To fix a lower rate: While it is a slippery slope, the idea is that you will take advantage of a window of time that is offering low interest rates. You refinance your home or vehicle, and get to pay less overall.
Under the right circumstances, these are all great reasons to refinance your home or car. However, there are pitfalls you will likely encounter along the way. Make sure you research the company you are using to refinance and consider the type of loan you are receiving. You want to avoid falling into any of the following traps.
- Fees associated with refinancing: Refinancing might offer some great benefits, but you have to make sure that they do not outweigh the risks. Transaction fees almost always apply, and sometimes they are high enough to counteract any financial benefit to refinancing. A reasonable origination fee should be no larger than 1 to 1.5 percent, and a loan processing fee should be no more than $400. There shouldn't be any extra fees tacked on like a "lock fee" or "courier fee." If there are, the company is probably not very honest.
- Recourse debt vs. non-recourse debt: In many states, a second mortgage is considered recourse debt. This means that the borrower is liable if the loan defaults. This puts you, your home, and all of your other assets at risk in the case of a major emergency that causes you to fall behind on payments. Usually, a first mortgage is considered non-recourse debt. In that case, you are not personally liable and the burden falls to your original lender. They have the option to seize the collateral you put down for the loan, but no more.
- Beware of "no closing cost" loans: These can actually be a great option when provided by a reliable company, and when the dominant market rate is 1.5 percent less than your existing rate. However, many shady companies try to lure in homeowners with the promise of no closing costs, but they end up charging a higher interest rate. This results in the borrower paying more in the long-term.
- Don't agree to arbitration: Some refinancing contracts ask you to agree to arbitration. This means that a third party will step in to resolve any conflicts that arise between the lending company and the borrower in lieu of going to court. While it sounds harmless, agreeing to an arbitration clause causes you to forfeit many of the rights you are granted as a homeowner.
- Watch out for pre-payment penalties: Some contracts will charge an extra fee if you pay off your loan early or sell your house before a certain time. Some shifty lenders will make the penalty as high as six months interest on 85 percent of the original loan balance. Check for any similar clauses before signing a contract.
You know you need to do something about your financial situation, and you're aware of the pitfalls. But how do you know if refinancing is right for your individual and family needs?
- Will you break even: This is the most important thing to consider when refinancing. Chances are, you aren't just looking to break even, you are looking to save money. There are a number of ways to determine your overall financial benefit, but one of the easiest and fastest ways is using an online calculator. As a guiding tool, an online refinancing calculator will take into consideration the points, closing costs, and other fees associated with refinancing. It can give you a rough estimate of whether or not you should move forward. A good rule of thumb is to avoid refinancing until the new rates are one percent lower than your rate.
- Know your credit score: If it's not so pretty, you probably want to clean it up before diving into refinancing. A poor credit score could lead you to higher rates and fees, ultimately causing you to lose money.
Of course, refinancing is a huge financial investment that shouldn't be taken lightly. It has the ability to really help you out, but it can also hurt you even more in the long run.