You've locked in a 30-year fixed-rate mortgage with an interest rate of 5%. That sounded great when you first got your loan, right? But you hear that interest rates will start to drop, which gets you excited. Although you can keep up with your mortgage payments, locking in a lower interest rate may help you save some cash.
It makes sense to refinance and save with lower rates, right? That may be true, but there are many factors you need to consider before signing on the dotted line. And there are cases when refinancing isn't the logical choice because it may have an impact on your financial situation. You might want to explore other real estate investment opportunities first. This article looks at four of the most common reasons why you shouldn't refinance your mortgage.
- Don't refinance if you have a long break-even period—the number of months to reach the point when you start saving.
- Refinancing to lower your monthly payment is great unless you're spending more money in the long-run.
- Moving to an adjustable-rate mortgage may not make sense if interest rates are already low by historical standards.
- It doesn't make sense to refinance if you can't afford the closing costs.
1. A Longer Break-Even Period
One of the first reasons to avoid refinancing is that it takes too much time for you to recoup the new loan's closing costs. This time is known as the break-even period or the number of months to reach the point when you start saving. At the end of the break-even period, you fully offset the costs of refinancing.
There's no magic number that represents an acceptable break-even period. There are a couple of different factors you have to consider to come up with a viable estimate. It depends on how long you plan to stay in the property and how certain you are about that prediction.
To calculate your break-even period, you'll need to know a couple of facts. The closing costs on the new loan and your interest rate are the most crucial. Once you know the interest rate, you can figure out how much you'll save in interest each month. You should be able to get an estimate of these figures from a lender. So let's suppose the closing costs to refinance amount to $3,000 and your potential monthly savings are $50. Here's how to calculate your break-even period:
- Break-even period = closing costs ÷ monthly savings
- $3,000 ÷ $50 = 60
In this instance, it will take you 60 months or five years to reach your break-even period.
2. Higher Long-Term Costs
Once you've spoken to your bank or mortgage lender, consider what refinancing will do to your bottom line in the long run. Refinancing to lower your monthly payment is great unless it puts a big dent in your pocketbook as time goes on. If it costs more to refinance, it probably doesn't make sense.
For instance, if you're several years into a 30-year mortgage, you've paid a lot of interest without reducing your principal balance very much. Refinancing into a 15-year mortgage will probably increase your monthly payment, possibly to a level that you won't be able to afford.
If you start over again with a new 30-year mortgage, you're starting with almost as much principal as last time. While your new interest rate will be lower, you'll be paying it for 30 years. So your long-term savings could be insignificant, or the loan may eventually cost you more. If lowering your monthly payment saves you from defaulting on a current, higher payment, you might find this long-term reality acceptable.
You might also want to consider the opportunity cost of the refinancing process. It takes time and effort to refinance a mortgage. You might have more fun and make more money doing home improvement projects, getting a certification, or looking for clients.
3. Adjustable-Rate vs. Fixed-Rate Mortgages
Refinancing to a lower interest rate doesn't always result in substantial savings. Suppose the interest rate on your 30-year fixed-rate mortgage is already fairly low, say 5%. In that case, you wouldn't be saving that much if you refinanced into another 30-year mortgage fixed at 4.5%. Once you factor in the closing costs, your monthly savings wouldn't be significant unless you have a mortgage several times larger than the national average.
So is there an alternative? Getting an adjustable-rate mortgage (ARM) may seem like a great idea because they typically have the lowest interest rates. It may seem crazy not to take advantage of them, especially if you plan to move by the time the ARM resets. When rates are so low—by historical and absolute standards—they aren't likely to be significantly lower in the future. That means you'll probably face substantially higher interest payments when the ARM resets.
Suppose you already have a low fixed interest rate and you're able to manage your payments. In that case, it's probably a better idea to stick with the sure thing. After all, an adjustable-rate mortgage is usually much riskier than a fixed-rate mortgage. Sticking with a low fixed rate may save you thousands of dollars in the end.
4. Unaffordable Closing Costs
There's no such thing as a free refinance. You either pay the closing costs out of pocket or pay a higher interest rate. In some cases, you're allowed to roll the closing costs into your loan. However, you are then left paying interest on closing costs for as long as you have that loan.
Consider all the costs associated with closing, including the application fee, the underwriting fee, and the processing fee.
Think about the closing costs and figure out how each one of these cases fits into your situation. Can you afford to spend several thousand dollars right now on closing costs? Or do you need that money for something else? Is the refinance still worthwhile at the higher interest rate? If you're looking at rolling the closing costs into your loan, consider that $6,000 at a 4.5% interest rate will cost thousands of dollars over 30 years.
The Bottom Line
The only person who can decide whether this is a good time to refinance is you. If you want a professional opinion, you are most likely to get an unbiased answer from a fee-based financial advisor. Refinancing is always a good idea for someone who wants to sell you a mortgage. Your situation, not the market, should be the largest factor in when to refinance.