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.
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.
Look to save a full percent in interest
A potential hazard here, then, is not getting a low enough interest rate to recover your costs in a reasonable time. If your new mortgage will only save you half a percent over the old one, it might take 10 years or more 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 your closing costs.
A related mistake is refinancing when you're going to be moving in a few years. If it's going to take you five years to recover the cost of refinancing, but you think you might be transferred to a new job in three or four, there's not much point in refinancing - you won't recoup the costs.
Some people assume they can avoid the above problems by taking out a "no-cost" refinance, where the closing costs are actually covered by paying a higher interest rate. So if the "no-cost" rate is lower than your current one, you're saving money, no matter how long you have it. The problem here is that these loans typically have steep prepayment penalties in the early years, so if you sell the home and move during that period, you're still stuck.
PMI may raise its head again
A potential problem that some people overlook in the current housing market is private mortgage insurance, or PMI. You may have avoided paying PMI by putting 20 percent or more down on your home when you first bought it. Or perhaps you put down less but were gradually able to acquire a 20 percent equity and have the PMI taken off.
However, if you refinance and your equity in the home has dropped below 20 percent due to falling housing prices, you'll have to get PMI on the new loan. Because PMI typically costs about half a percent of your loan balance per year, it's like an extra half a percent on top of your mortgage interest rate - and has to be accounted for when determining if the new loan will save you money.
Look out for changes in terms
Finally, one of the big things to look out for is a mortgage that may have certain terms that are less desirable than your current home loan. For example, prepayment penalties that last several years and which could complicate future efforts to sell the home or refinance again.
Or perhaps you've got 23 years left on a 30-year loan and don't want to start all over again at 30 years. In this case, many banks offer fixed-rate loans in 5-year increments - so you can take out a 20- or 25-year refinance if you don't want to add another seven years back onto your loan. Some banks will also allow you to refinance into a 40-year loan, which can be useful if you really need to lower your monthly payments. But extending the term of your loan through a refinance means you'll be paying more over time due to the accumulated interest.
Be smart about ARMs
Another change in terms to be cautious about is switching from a fixed-rate to an adjustable rate mortgage (ARM). Although ARMs can offer substantial savings - with original interest rates often a full point less than comparable fixed-rate loans - you need to be careful you don't get stuck when the rates start to reset three, five, seven or 10 years down the road. The key is to make sure you'll have enough equity in the home at that time - even if housing values continue to fall - that you can refinance again if need be.
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.