Choosing to refinance a mortgage isn't an automatic decision - you need to weigh the pros and cons. There are a few potential pitfalls to avoid as well. Here are some of the main ones to be aware of.
Just like with a home-purchase mortgage, you need to pay closing costs when you refinance. These typically run from 3-6 percent of the loan amount, with the higher figure usually involving buying discount points to reduce the rate. Bottom line: you need to make sure you'll save enough by mortgage refinancing to offset your closing costs.
Extending the term
Be wary of refinancing into a new 30-year fixed-rate mortgage when you've already been paying one down for several years. You may reduce your monthly mortgage payments, but you could easily end up paying a lot more in interest over the life of the loan, even with a lower rate, because you've extended your payoff date. 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, so you keep your mortgage interest costs under control.
Risk of default
With a cash-out refinance for debt consolidation or any other purpose, you're putting your home on the line. Defaulting on those other debts won't put your home at risk; but if rolling those debts into your mortgage raises your payments too much, you could lose your home.
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. A good rule of thumb is to wait until rates have fallen at least a full percentage point below your current rate before refinancing.
With some mortgages, you have to pay a prepayment penalty if you pay it off or refinance it before a certain time has passed, often 1 to 5 years. This is often the case with "no cost" mortgages where the lender charges a higher interest rate in lieu of closing costs, and needs to charge those rates for several years to make up the difference.
Not enough time to benefit
There's not much point in refinancing a home you're only going to be in for a few more 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.