Pros and cons of refinancing your home
- There's more to think about than interest rates.
- At its best, refinancing allows for lower loan payments and faster payoffs.
- It takes time to recoup the costs of refinancing.
- The structure of the new loan is critical.
- Refinancing to pay off credit-card debt requires discipline.
When interest rates are falling and home equity levels are rising, refinancing a home mortgage often seems like a good idea, and many times it is — but not always.
Like most other financial decisions, determining whether to refinance requires weighing some arguments for and against embarking on such a transaction.
With refinancing, the list of pros and cons are not strictly financial. Sometimes, determining whether refinancing is a good idea boils down to how wisely you can structure the new loan, or how much self-discipline you're prepared to apply in the years after refinancing.
Refinancing is popular because it comes with a number of advantages especially when rates are low.
When interest rates are falling, the most basic argument in favor of refinancing is the prospect of lower monthly mortgage payments. Sometimes, borrowers find that it makes sense to refinance more than once, even when weighing in the costs of refinancing.
If interest rates fall, and you're willing to make the same monthly payment, or close to it, you can significantly reduce the amount of time it takes to pay off your home loan. Depending on how much lower interest rates are than when you bought the house (or than the last time you refinanced), it may be possible to both lower your monthly payment and reduce the term of the loan.
Refinancing may allow you to move from an adjustable-rate mortgage (ARM) to a fixed rate on terms that make financial sense. When interest rates are low, the difference between the introductory rate for an ARM (the low rate you get at the beginning of a loan) and a fixed-rate loan is quite minimal. True, if you move to a fixed rate, your payment may go up a bit, but you will be able to lock in a rate that could otherwise, by historical standards, go much higher over the course of a 30- or even 15-year ARM loan.
Money in your pocket
If you have built equity in your home, you can use a refinanced loan to cash out that equity. The process can make particularly good financial sense if you use the money to pay off other more expensive debt, such as credit cards. Cashing out the equity in your home also can be a way to fund a business startup or to pay for college tuition.
Freedom to choose
When you're initially financing a home purchase, there's usually some pressure to get the deal done quickly. There's less urgency when you're refinancing, and more time to shop around and negotiate with lenders.
Don't overlook the price of refinancing as well as its potential impact on your debt and taxes.
Refinancing is costly. Banks charge fees, as do appraisers, title companies, lawyers and other professionals. If you're refinancing a relatively small loan, the fees become a more significant consideration, since they'll take up a larger percentage of the loan than they would if you were refinancing a larger loan. It's also costly in terms of your time: There is a lot of paperwork involved and, since the housing crash, more documentation required to prove how much money you make and how much you have in the bank.
This is where it's important to consider whether you are structuring the loan properly. If you're 10 years into a 30-year loan and refinance into a new 30-year loan at a lower interest rate, you will certainly see some savings in your monthly mortgage bill. But you also will add another 10 years to the term of the loan and will likely end up paying more over the life of that loan than if you would have chosen not to refinance.
If you pursue a cash-out refinance to, in part, pay off credit card bills, you should be prepared to really do something about your credit card habits. After you pay down the credit cards using the funds from the refinancing loan, it's easy to run up substantial new credit card debt and find yourself in worse financial shape than before you refinanced — not to mention you're putting your home at risk.
Because of the refinancing fees, no matter how much you lower your interest rate, it will take some period of time to recoup the cost of the new loan. If you reduce your monthly payment by $200 through refinancing, for instance, but the process cost you $4,000 in points and fees, it will take 20 months before you break even. If you sell your home in less than 20 months, you've lost money on the refi deal.
If you cash out when you refinance your loan, you lose some of the mortgage-interest tax deduction cushion that you enjoyed with the original loan. You can deduct the interest from the refinance loan if you're using the cash drawn out to "buy, build or improve" your home or a second home. If you use the money for another purpose, however — such as paying off credit card debt, or funding college tuition —the interest is deductible only on the first $50,000 of the new loan for a single person and on the first $100,000 for a couple.