You're 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're able to keep up with your mortgage payments, locking in a lower interest rate may help you save some cash, so it makes sense to refinance, right? That may be true, but there are a lot of 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. This article looks at four of the most common reasons why you shouldn't refinance your mortgage.

Key Takeaways

  • 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 significantly low.
  • It doesn't make sense to refinance if you can't afford the closing costs.

A Longer Break-Even Period

One of the first reasons to avoid refinancing is it takes too long for you to recoup the closing costs of the new loan. This is known as the break-even period or the number of months to reach the point when you start saving, thereby offsetting the costs of refinancing.

One important point to note, though. There's no magic number that represents an acceptable break-even period. There are a couple of different factors you have to consider in order 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.

In order to calculate your break-even period, you'll need to know a couple of things—the closing costs on the new loan and your interest rate. 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.

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 doesn't really make sense, does it?

For instance, if you're several years into a 30-year mortgage, you've paid a lot of interest without putting much of a dent in your principal balance. 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 you had at the beginning of your current mortgage. While your new interest rate will be lower, you'll be paying it for 30 years. So your long-term savings may very well be insignificant or the loan may even cost you more over time.

If lowering your monthly payment means the difference between staying current on a new, lower payment and defaulting on a current, higher payment, you might find this long-term reality acceptable.

Adjustable-Rate vs. Fixed-Rate Mortgages

Refinancing to a lower interest rate doesn't always result in substantial savings. For instance, if the interest rate on your 30-year fixed-rate mortgage is already fairly low—say 5%—you wouldn't be saving that much more if you refinanced into another 30-year fixed at 4.5%. Once you factor in the closing costs, your monthly savings wouldn't be that drastic, 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 available. 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. This means you'll probably face significantly higher interest payments when the ARM resets.

If you already have a low fixed interest rate and you're able to manage your payments, 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. It may save you thousands of dollars in the end.

Unaffordable Closing Costs

There's no such thing as a no-cost refinance. You either pay the closing costs out of pocket or you pay a higher interest rate. In some cases, you're allowed to roll the closing costs into your loan, but then you're paying interest on them for as long as you have that loan.

Consider all the costs associated with closing including the application fee, the underwriting fee, the processing fee, and others.

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 4.5% interest for 30 years will cost you approximately $5,000 extra in the long run compared to just paying the money out-of-pocket now.

The Bottom Line

The only person who can decide whether it's a good time to refinance is you. If you want a professional opinion, you'll be more likely to get an unbiased answer from a fee-based financial advisor rather than from someone who wants to sell you a mortgage. The details of your individual situation, not the market, should be the biggest determining factor in whether you choose to refinance.