There are a lot of advantages to refinancing your mortgage. But what about the downsides? Are there any disadvantages borrowers need to be aware of before taking out that new loan?
As with most decisions in life, there are both positives and negatives to refinancing a mortgage. Even with interest rates as low as they are right now, there are still potential pitfalls to avoid. Fortunately, most of these can be avoided by choosing the right mortgage - only a few are outright deal-breakers.
Here are some of the main things to look out for.
The number one downside to refinancing is that it costs money. What you're doing is taking out a new mortgage to pay off the old one - so you'll have to pay most of the same closing costs you did when you first bought the home, including origination fees, title insurance, application fees and closing fees.
These days, you'll likely have to pay for a new appraisal as well, since most homes have declined in value over the past few years and the new lender will be unwilling to loan you more than the property is worth - they'd rather leave that burden on your current lender!
Refinancing will generally cost you from 2 - 6 percent of the amount borrowed, depending on where you live, though most borrowers tend to pay toward the lower end of that range. The key then, is to make sure you're saving enough by refinancing to make the transaction worthwhile.
Not saving enough
So how do you know if you're saving enough by refinancing? If you can recover your closing costs in a reasonable time. If your new mortgage rate is only half a percentage point lower than the old one, it might take 7-10 years to recoup the costs of refinancing. The general rule of thumb is that you want to save a full percent or more to make refinancing worthwhile, depending on how much your closing costs were.
The way to tell if you're saving enough is by calculating your "break-even point" – how long it will take your savings from a lower mortgage rate to exceed your closing costs. You can use a refinance break-even calculator to determine how long this would be.
You generally want to be able to recoup your costs within five years or so. Many homeowners relocate after 5-7 years in the same property, so if you move before you reach the break-even point, you won't recover your refinance costs. But if you expect to stay in the home for a long time, you can allow more time to reach your break-even point.
Stretching it out
If you've had a 30-year mortgage for a number of years, you probably don't want to refinance your home into a new 30-year loan. That might lower your monthly payments, but it also postpones the day you own your home free and clear. And because of the way compounding interest works, it could cost you more over the long term, even if you reduce your mortgage rate in the process.
It's better to choose a 15-, 20- or 25-year term that more closely matches the time you have left on your original home loan. And since shorter-term loans have lower mortgage rates, you can often chop a few years off your loan without increasing your monthly payment.
A "no-cost" refinance could cost you
Some mortgage lenders advertise what they call a "no-cost" refinance, where there are no separate charges for closing costs. But a no-cost refinance isn't free; the lender charges a higher mortgage rate to compensate.
A no-cost refinance can be attractive if you're short on cash and don't want to pay your closing costs out of pocket. But over time, that higher interest rate adds up.
A no-cost refinance might be advantageous if you expect to sell the home or refinance within a few years. But over 10-30 years, you'll likely pay a lot more in mortgage interest than you'd save in closing costs. So keep that in mind. Use a mortgage calculator to figure how much more you'd be paying in interest every year and how long it would take that to exceed the closing costs you'd save.
Getting too aggressive
Refinancing to a 15-year fixed-rate mortgage can be attractive, with their very low rates and the prospect of paying off your mortgage much faster. However, a shorter term also means paying more in principle each month, which can significantly increase your payments. Don't bite off more than you can chew.
Refinancing too often
When mortgage rates are falling, borrowers sometimes fall victim to the temptation to chase after ever-lower rates, refinancing each time rates drop by a quarter or half a percentage point. And each time, they pay a new round of closing costs that eats into or even exceeds their savings from refinancing. As mentioned above, a good rule of thumb is to wait until rates have fallen at least a full percentage point below your current rate before refinancing.
Moving on too soon
There's not much point in refinancing a home you're planning to move in a few years. The same is true for when you've only got a few years of payments left on your mortgage.
If moving to a new home is part of your intermediate-range plans, you may not be in the current one long enough to see much of a gain from refinancing. If it's going to take four years to reach your break-even point (the point where your accumulated savings in interest exceed your closing costs) and you expect to move in about five, you have to wonder if refinancing would be worthwhile.
Similarly, if you've only got a few years left on your existing mortgage, you might not save that much in mortgage interest even with the best refinance rates. The share of your monthly mortgage payment that goes toward interest falls rapidly in the latter years of your loan, so the potential savings are reduced as well.
Note that these are for situations where you refinance to reduce your mortgage rate; there might still be advantages to a cash-out refinance or refinancing to extend your term and reduce your payments in such situations.
Don't be intimidated
Refinancing is a process that can seem intimidating to some people, but it needn't be - if anything, it's simpler than taking out the original mortgage you used to buy the home. But basically, as long as you can lower your mortgage payment enough to recoup your costs in a reasonable time and avoid the other pitfalls above, it's a sound and straightforward financial move to make.