Many homeowners assume they should refinance any time rates get lower. While it might be nice to save money on your monthly payment, it doesn’t always pay to refinance. In fact, refinancing has some negative sides that you may not even know.
Keep reading to see the good and ‘bad’ sides of refinancing to make the choice that is right for your family.
The Benefits of Refinancing
First, we’ll look at the benefits of refinancing because there are many.
- You may lower your interest rate/payment – The fact that you can lower your interest rate is the largest benefit. If rates drop since you took out your original mortgage, you may want to save money each month. This, in turn, could lower your monthly mortgage payment. If you struggle to make ends meet with your current mortgage payment, it could be beneficial to snag that lower payment.
- You may get a better term – Many borrowers automatically take a 30-year loan because it has the lowest payment. If you find yourself in a positive financial position, though, you may want to take a lower term. This allows you to pay your loan off faster and pay less interest over the life of the loan.
- You may eliminate mortgage insurance – If you pay mortgage insurance, you probably want to do whatever you can to eliminate it. If you have a conventional loan, you may be able to have the PMI removed by requesting elimination of it from the lender. IF your home appreciated and/or you paid your balance below 80% of the home’s value, the lender may cancel it. FHA loans, though, have mortgage insurance for the life of the loan. If you put yourself in a better financial position, you may be able to refinance into a conventional loan and eliminate the mortgage insurance.
- You may use your home equity – If you have a decent amount of equity in your home, you may be able to use it by refinancing. Whether you need the money to improve your home, pay for college tuition, or consolidate debt, there are loan programs that give you access to your home’s equity.
The Disadvantages of Refinancing
As good as the benefits of refinancing sound, there are some downsides to it. Keep the following in mind when you decide if refinancing is right for you.
- You may restart your loan’s term – If you refinance just to get a lower rate or lower your monthly payment, you may restart your original term. Let’s say you had a 30-year term and you refinanced into another 30-year term after five years. You just lost the 5 years that you made headway on your mortgage. In other words, you added five years to your loan’s term. This could add up to a large amount of extra interest paid on the loan.
- You pay closing costs – Every time you take out a new mortgage, you pay closing costs, not just when you buy the home. You may have the option of a no-closing-cost refinance, but then you’ll pay a higher interest rate, which may defeat the purpose of refinancing.
- You could lose equity in your home – If you decide to take cash out of your home’s equity, you will have a higher loan-to-value ratio. This can be risky if home values fall or you want to sell your home in the near future. The less equity you have, the less cash in hand you receive at the closing. Even if you stay in the home and you are upside down (owe more than its value), it could be financially disastrous.
What’s Your Break-Even Point?
One thing every homeowner should figure out before refinancing is the break-even point. Unless you refinance to have access to your home’s equity, you’ll want to know the break-even point.
The break-even point is the time when you pay off the closing costs for the refinance and realize the savings on the new loan. Just because you can have a lower mortgage, payment doesn’t mean it’s necessarily worth it. What if it takes you 10 years to pay off the closing costs? It’s probably not worth the cost of refinancing.
There isn’t a rule that states how much money you must save in order for it to make sense, though. You’ll have to judge what is right for your own situation. You can determine your break-even point by doing the following:
- Total up the closing costs for the refinance
- Figure out the monthly savings you’ll earn by refinancing
- Do the following calculation: Total closing costs/Monthly Savings = Break-even point
You can then use that break-even point to decide if refinancing makes sense. The number you come up with is the number of months it will take to recapture your closing costs. You can use that as a guide and ask yourself:
- Will I move before the recapture point?
- Do I want to pay costs that take “x” amount of time to pay off?
- Is the savings worth the refinance?
As you evaluate the pros and cons of refinancing, you can see how they pertain to your situation. Some people benefit greatly from refinancing and others don’t benefit at all. It’s not a one-size-fits-all situation, but rather up to individual discretion.