Mortgage refinancing is not always the best idea, even when mortgage rates are low and friends and colleagues are talking about who snagged the lowest interest rate. This is because refinancing a mortgage can be time-consuming, expensive at closing, and will result in the lender pulling your credit score.
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 flows, dealing with a financial emergency, or paying off your home loan sooner—can be met with a refinance, here are seven bad reasons to refinance your mortgage.
- Refinancing your mortgage can be either a good or bad idea, depending on your motivation and goals as well as the financial terms of the refi.
- Many consumers who refinance to consolidate debt end up growing new credit card balances that may be hard to repay.
- Homeowners who refinance can wind up paying more over time because of fees and closing costs, a longer loan term, or a higher interest rate that is tied to a "no-cost" mortgage.
1. To Consolidate Debt
Consolidating debt is often a good thing, but it has to be done right. In fact, debt consolidation done wrong can end up being 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 potential pitfalls.
First, you are transferring unsecured debt (such as credit card debt) into debt that is backed by your home as collateral. If you are unable to make your mortgage payments, you can lose that home. While nonpayment of credit card debt can have negative credit score consequences, they are usually not as dire as a foreclosure.
Second, many consumers find that once they have repaid their credit card debt, they are tempted to spend again and will begin building up new balances they will have more trouble repaying.
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 to look at the overall cost of the loan. For instance, if you have 10 years left to pay on your current loan and you then stretch out the payments into a new 30-year loan, you will end up paying 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, that means you are not saving any money at all—despite the lower monthly payments.
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 adjustable-rate mortgage (ARM) should carefully look at their terms before making a move to refinance.
If you have an ARM, make sure you know the index to which it is tied; how often the loan adjusts; and what the caps are on loan adjustments for the first cap, annual cap, and lifetime cap. It may be that a fixed-rate loan is better for you, but do the math before committing to spending money on a refinance.
5. To Take Cash Out for Investing
Even when the stock market isn't rocky, this is not a generally good idea. The problem with cash is that it is too easy to spend. If you are disciplined and will truly use the extra money to invest—or to build your emergency fund—this can be a good option. However, paying down a mortgage at 4% 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 who understands both the risks and potential upside before playing with the equity in your home.
6. To Reduce Your Monthly Payments
In general, reducing your monthly payments by lowering your interest rate makes financial sense. But don't ignore the costs associated with refinancing. In addition to the closing costs and fees, which can range from 2% to 3% of your home loan, you will be making more mortgage payments if you extend your loan terms.
If, for example, you have been making payments for seven years on a 30-year mortgage and refinance into a new 30-year loan, remember 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.
Comparing the amortization schedule of your current mortgage to the amortization schedule of the new mortgage will reveal the effect a refinance will have on your net worth.
7. To Take Advantage of a No-Cost Refinance
A "no-cost" mortgage loan does not exist, so be careful when you see such an offer. There are several ways to pay for closing costs and fees when refinancing, but in every case, the fees are paid in one way or another. In other words, 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 or including closing points. You can calculate the best way for you to pay the costs by comparing the monthly payments and loan terms for each scenario before choosing the loan that works best for your finances.
How Often Can You Refinance Your Home?
While there are no regulations that cap how often you can refinance your home, lenders typically set their own limits. Some also impose prepayment penalties on existing loans. Your ability to refinance also depends on the equity you have in your home and your credit score. If your score is lower than the last time you refinanced, you may not get approval from your lender.
Finally, keep in mind that every time you refinance, you'll pay closing costs and fees which can take years to recoup and your credit will be pulled by lenders, which can negatively impact your credit score if done too frequently.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
The Bottom Line
Refinancing a mortgage can be a wise financial move for many homeowners, especially if they need more than mortgage relief can provide, but not every refinance makes sense. Be sure to evaluate all your options before making a decision.