With all the refinance advertisements and offers in the marketplace today, you may be wondering if refinancing your mortgage is the right decision. There are several benefits to a refinance, but the positives should be carefully weighed against the negatives before moving forward.
Most people refinance their mortgage to obtain a lower interest rate, lower their monthly payment, to move from an adjustable rate to a fixed rate, or to consolidate debt. While each of these items can seem like a justifiable reason, you should only conduct a refinance if it improves your overall financial situation. There are many costs involved, these need to be strongly considered.
First of all, there is no such thing as a no-cost refinance. If the lender pays your closing costs, they will charge you a higher rate on the loan to compensate. A refinance will generally cost about 2% to 5% of the loan’s principal. Another consideration is the term of the loan. If you refinance to a new 30-year loan after being 10 years into an existing 30-year mortgage, this will push out the completion date of the debt payoff. Pushing this date out will reduce the rate that you are building equity. When a loan begins, more interest is paid than is principal from your monthly payment. However, as time goes on more is being paid to principal each month. You can see this broken out in a loan’s amortization schedule. Resetting it is often a substantial cost that is not considered when comparing lower interest rates and monthly payments. The best way to mitigate this problem is to structure your new loan to mature at the same time as your existing loan, or preferably have it end even earlier.
Refinancing to move to a fixed rate loan from an ARM (adjustable-rate mortgage) can make sense, especially if an increasing mortgage could cause budget problems. However, the frequency of ARM rate resets and the underlying benchmark rate that the mortgage is tied to should be considered, along with your personal situation. It may not make sense to pay the costs of a refinance if you are going to sell the home in a short period of time. This is true for most reasons to refinance. A person should always consider how long it would take for these costs to be made up by the interest savings and/or increased equity build. After this breakeven point, the refinance becomes beneficial and it would be ok to sell the home, but not before.
Using a refinance to consolidate other debt such as credit cards will usually make sense on paper, but only if new debt is no longer accrued moving forward. By securing higher rate debt with the home, it is possible to get a lower rate, but at the cost of equity in an appreciable asset. Also, because your home is tied to the debt, you are putting this asset at greater risk if new high-rate debts are opened up again after the refinance. This would suggest that a consistent budget shortfall needs to be addressed first. Also, you should not cash out your home equity to invest in other assets, such as stocks. You should view your home equity as an investment in a different type of asset class that adds diversification in your overall portfolio.
Since the costs of a refinance can be significant, you should always consult a financial advisor. They can compare rates and your personal financial situation to make the appropriate recommendation.