Last Updated on May 28, 2017 by Andrew Lee
Refinancing presents a great financial strategy as long as conducted carefully and properly. It can help you minimize mortgage payments, reduce interest rates and shorten the time you are in debt. However, this valuable tool can work against you if you don’t take the time to review its potential drawbacks. Note also that practicing smart financial habits is key to minimizing risks of defaulting on your loan, while also helping you save money. This also involves knowing when and when not to opt for mortgage refinancing.
When you refinance your current home loan, you basically pay off your existing housing loan and replace it with a new one. There are many good reasons to do this, including securing lower interest rates, becoming mortgage-free in a shorter period of time or switching from a Fixed-Rate Mortgage (FRM) to an AdjustableRate Mortgage (ARM) one (or vice-versa) when it can minimize your expenditures. Keep in mind though, that this isn’t for everyone. So before you push through with a refinancing plan, make sure that you understand all its implications, both the positive and the negative.
When it makes sense
Here are some of the situations that will motivate you to opt for refinancing.
1. If you can reduce the interest rate by no less than 1%.
If refinancing will reduce the interest rate on your current loan, then you should check mortgage refinance rates and compare them as soon as possible. Don’t forget this rule of thumb though: refinancing will only benefit you if it can bring down your rate by at least 1%. If it won’t, then you might be better off sticking with your current mortgage. Having to pay a lower interest rate doesn’t just help you cut back on costs, which helps you save a lot; it also speeds up the accumulation of equity in your home. It makes it easier for you to make your monthly payment, as you would need to pay less towards your loan every month.
2. Becoming mortgage-free sooner.
Another reason for refinancing is to shorten a loan’s term – the amount of time you have to pay off your debts. A drop in interest rates give many homeowners the opportunity to exchange their existing loan for a new one that comes with a shorter term with the same monthly payment. You would still pay roughly the same amount every month, but you can get out of this huge debt sooner, allowing you to live your life with fewer financial responsibilities.
3. Swapping your current loan for another mortgage type.
Many borrowers also refinance a mortgage to switch from an adjustable-rate to a fixed-rate loan. They perform the conversion so that they can minimize the effects of an interest rate that can change and make their monthly payment higher than they can afford.
The periodic adjustments of ARM rates put borrowers at risk of exorbitant monthly payments. So those who can’t pay off their ARM before its rate starts to change most likely would have to put up with constantly-changing (which, in most cases, means higher rates) expenditures. With refinancing, they can get rid of this uncertainty, seeing as they can change their existing mortgage to one with a fixed rate.
Conversely, homeowners can also convert their FRM to an ARM as part of a sound financial strategy. This makes sense if the mortgage rates show a continuous drop and believed to continue doing so. Also, you may want to implement this strategy if your plans of living permanently in the same home changes, and you would likely move out and to a new place several years from now.
When refinancing is an unwise choice
Sticking to your current mortgage is a better option over refinancing in the following cases:
1. You still have a poor credit score and rating.
Lenders use a myriad of factors when determining both mortgage and refinance mortgage rates and credit score is one of them. Having a good score means greater potential for lower rates, while a poor score increases risk of higher rates. Even if you find a lending institution willing to refinance your current housing loan, you can expect to pay more for it. So, hold off on your refinancing plans until you’ve had the chance to improve your credit score.
2. You’ll have trouble covering closing costs.
Mortgage refinancing can save you a lot and even assist in paying off your mortgage faster but you won’t benefit from it if you’ll still find it difficult to pay for closing costs. Even if you have relatively low closing costs to think about, they can quickly add thousands and thousands of dollars to your overall mortgage expenses. And this doesn’t just reduce your home’s equity, it also puts you at risk of having to make higher monthly payments.It is wise to carefully assess all expenses associated with your mortgage first, before you sign that refinancing contract. Save up as much as you can so you can easily afford closing costs, and once you do, check mortgage refinance rates again to see if you can afford to push through with it.
3. Long-term expenditures greatly outweigh what you’ll save.
As mentioned above, refinancing isn’t for everyone. Just because your neighbor benefitted from it doesn’t automatically guarantee you will too. It can work against you if you’ll have potential long-term expenditures much greater than what you can actually save. Say for instance, you’ve already paid a lot towards your existing loan for quite some time now but the majority of the payments you made only went towards the interest. Refinancing into a new 30-year term may result in lower monthly payments but a great portion of these will only just go towards the interest again. As a result, you’ll spend even more for a longer period of time even if you will spend less on a monthly basis.