When mortgage rates dip and the office chatter focuses on who snagged the lowest interest rate, it can be tempting to contact a lender and sign on for a mortgage refinance. But before you begin the long process of gathering pay stubs and bank statements, think about why you are refinancing. While some financial goals such as easing your monthly cash flow or paying off your home loan sooner can be met with a refinance, there are plenty of scenarios in which a mortgage refinance can be a mistake. (For more, see Mortgages: The ABCs Of Refinancing.)
IN PICTURES: Top Homebuyer Tradeoffs
1. To Consolidate Debt
This can be one of the most dangerous financial moves any homeowner can make. On the surface, paying off high-interest debt with a low interest mortgage seems like a smart move, but there are some potential problems. First, the homeowners are transferring unsecured debt (such as credit card debt) into debt that is backed by their home. If they are unable to make their home loan payments, they can lose the home. While nonpayment of credit card debt can have negative consequences, they are usually not as dire as a foreclosure.
Second, many consumers find that once they have repaid their credit debt, they are tempted into spending again and will begin building up big balances that they will have more trouble repaying. (For more, see: A Lifeline For Those Drowning In Debt.)
2. To Move Into a Longer Term Loan
While refinancing into a mortgage with a lower interest rate can save you money each month, be sure also to look at the overall cost of the loan. If you have ten years left to pay on your current loan and you stretch out the payments into a 30-year loan, you will pay more in interest overall to borrow the money and be stuck with 20 extra years of mortgage payments.
3. To Save Money for a New Home
As a homeowner, you need to make an important calculation to determine how much a refinance will cost and how much you will save each month. If it will take three years to recoup the expenses of a refinance, and you plan to move within two years, then, despite the lower monthly payments, you are not saving any money at all.
4. To Switch from an ARM to a Fixed-Rate Loan
For some homeowners, this can be an excellent move, particularly if you intend to stay in the home for years to come. But homeowners who are simply afraid of the bad reputation of an ARM should carefully look at their ARM terms before making a move to refinance. If you have an ARM, make sure you know what index it is tied to, how often your loan adjusts and, even more important your caps on the loan adjustments: the first cap, the annual cap, and the lifetime cap. It may be that a fixed-rate loan is better for you, but make sure you do the math before committing to spending money on a refinance. (To learn more, see ARMed And Dangerous.)
5. To Take Cash Out for Investing
The problem with cash is that it is too easy to spend. If you are disciplined and will truly use the extra money for investing, this can be a good option. However, paying down a mortgage at 5-6% per year can be a better deal than plunking your cash into a CD that earns 2% every year. Make sure you are a savvy investor before playing with the equity in your home.
6. To Reduce Your Payments
In general, reducing your monthly payments by lowering your interest rate makes financial sense. But don't ignore the costs of refinancing. In addition to the closing costs and fees that can cost from 3-6% of your home loan, you will be making more mortgage payments if you extend your loan terms. For example, if you have been making payments for seven years on a 30-year mortgage and refinance into a new 30-year loan, remember that you will be making seven extra years of loan payments. The refinance may still be worthwhile, but you should roll those costs into your calculations before making a final decision.
7. To Take Advantage of a No-Cost Refinance
A "no-cost" mortgage loan does not exist. There are several ways to pay for closing costs and fees when refinancing, but in every case, the fees are paid one way or another. Homeowners can pay cash from their bank account for a refinance, or they can wrap the costs into their loan and increase the size of their principal. Another option is for the lender to pay the costs by charging a slightly higher interest rate. You can calculate the best way for you to pay the costs by comparing the monthly payments and loan terms in each scenario before choosing the loan terms that work best for your finances.
The Bottom Line
A mortgage can be a wise financial move for many homeowners, but not every refinance makes sense. Be sure to evaluate all your options before making a decision. (For more on this topic, check out Should You Refinance Your Mortgage?)