Refinancing your mortgage can be a great way to save money, but it's not a sure thing. Before you take the plunge, ask yourself these six questions to avoid making a major money mistake. (For a background reading, see our Mortgage Basics Tutorial.)
Tutorial: Mortgage Basics
1. Do I have the time to spare?
This question is very basic, but you shouldn't overlook it. If you're already very busy with work or other major obligations, it may be in your best interests to wait until you have more time to deal with the details of the loan. If you are too busy or stressed out, you might make a mistake, missing something important in the fine print or falling prey to a bad loan. Refinancing should be done with the same extreme care you put into getting your original mortgage - it's just as big of a decision.
2. Will I break even or come out ahead?
Most people assume that refinancing will put them ahead, otherwise, they wouldn't do it. But how realistic is this assumption? Any number of situations could arise - from work relocation to family emergency – that could influence your financial situation and make your decision to refinance an unprofitable one. Unfortunately, it's not possible to predict with complete accuracy whether you will own the home long enough to come out ahead on a refinance, but you can make an educated guess. Since it is possible to lose money on a refinance, it's important to consider whether you can afford that risk. (For more, see Home Equity Loans: The Costs.)
3. Am I disciplined enough to resist rolling other debt into my mortgage?
It might sound like a good idea to pay off some of your other debts by refinancing them into your mortgage. Why owe money to multiple people and make multiple debt payments every month, when you could have just one debt and just one major monthly payment, all at a low interest rate? Well, let's use an auto loan as an example. Auto loans often have higher rates than mortgage loans (depending on what market conditions were like when each loan was taken out, of course), but they also have fairly short terms. If you take that short-term loan and turn it into a 30-year loan, even at a lower interest rate, you're likely to end up paying more. You didn't think the bank was offering to consolidate your debt out of the kindness of its heart, did you? Banks are businesses. They're in it for the profit and if they can stretch out a loan for you, they're often happy to do it because it allows them to collect more interest.
4. Am I likely to qualify for the rate I want?
The current interest rates for a refinance quoted on major financial web sites and the evening news can only give you a general idea of what interest rate you might be able to get. The details of your specific situation, such as your credit score and the type of loan you want to refinance into, will affect the rates actually available to you. If you don't qualify for the lowest advertised rates, is it still worthwhile to refinance? Talk to a few lenders to see what kind of rate you can expect, but keep in mind that the unscrupulous ones will quote any rate to get your business. If you trust the person who did your first mortgage, that's a good place to start your research. (For more on this topic, read 7 Low-Rate Mortgage Shams.)
5. Can I meet today's tighter lending standards?
If you took out your last mortgage before the housing bubble, when no-doc loans were commonplace, you may be stunned by the borrower requirements and documentation requirements to refinance in today's market. Many lenders will want you to have a high credit score and ask you to provide full documentation of your financial situation, such as recent pay stubs, bank account statements, tax returns and more.
6. Can I prevent going from a good loan to a bad loan?
If you're not savvy when it comes to money, contracts and salespeople (in this case, loan officers), or you just don't trust yourself to not make a mistake, refinancing might not be in your best interest. If you know you have a good loan, you may not want to roll the dice and see what you end up with when you refinance. And if you already have a bad loan, refinancing will be useless if you just end up in another bad loan. Also, there's always the risk of bait and switch - just like when you first bought your home, a lender may quote you one interest rate and set of fees on the day you decide to work with them and give you something entirely different when it's time to sign the paperwork.
The Bottom Line
Yes, refinancing can be a great way to save money. If you do it right, you can improve your short-term cash flow while also increasing your long-term net worth. But a bad refinance can put you in a situation where the only person benefiting is the loan officer. If your answer to any of the questions in this article is "no," you may be better off looking for simpler ways to decrease your expenses, such reviewing your insurance policies, cutting your grocery bill or looking for ways to lower other household bills. (Be sure to read Should You Refinance Your Mortgage When Interest Rates Drop? for more refinancing tips.)