A nicer car. Some new furniture. A family vacation. Or a bigger, fatter savings account every month. They’re just a few of the things you’ve been thinking about since you learned you can save a couple hundred dollars per month by refinancing.
We get it. That new low interest rate is tempting. But is refinancing really right for you? If you’re only thinking about what you can buy with the money you’ll save, the answer might be no.
WHEN TO REFINANCE
1. To lower your interest rate
“One of the best reasons to refinance is to lower the interest rate on your existing loan,” said Investopedia.
“Historically, the rule of thumb was that it was worth the money to refinance if you could reduce your interest rate by at least 2%. Today, many lenders say 1% savings is enough of an incentive to refinance.”
People who refinanced a few years ago may also want to think about doing it again. “If they refinance now, they could lower their rate by 1 percent,” said Diane George, founder of Vault Realty Group, a brokerage in Oakland, California, in Money magazine. “For example: A $450,000 loan with a 4.75 percent interest rate refinances into a 3.6 percent interest rate and will have a savings of an estimated $300 a month.”
2. To shorten your loan term
Historically low interest rates have enticed many a homeowner to refinance in order to shorten the length of their loan—often trading in a 30-year fixed-rate loan for a 15-year term. Depending on the rate, homeowners can cut their loan term nearly in half without a huge jump in the monthly payment. Check out Bankrate’s calculatorto compare rates on the two loan types.
3. To get a fixed-rate mortgage
If your loan is adjustable and you’re looking to get a fixed rated with payments that remain the same every month, a refi is a good idea, say experts. “While ARMs start out offering lower rates than fixed-rate mortgages, periodic adjustments often result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to a fixed-rate mortgage results in a lower interest rate as well as eliminates concern over future interest rate hikes,” said Investopedia.
4. To use your home equity to pay off debt
If your home has risen in value while you’ve been making your payments and interest rates have dropped, you may have a nice chunk of equity in your home. Tapping that equity to pay off existing debts may make good financial sense—especially when the interest rates on your credit cards and store accounts are higher than the rate offered by your refi.
WHEN NOT TO REFINANCE
1. Because you want to cash out all that equity and buy a boat. Or an island
If there’s one thing we learned from the real estate crash, it’s that treating our homes like a discretionary spending account can be dangerous. Mortgaging yourself to the hilt and spending the cash on items that don’t appreciate or that are risky could spell disaster—that’s if a bank will even approve the refi.
It’s also important to remember that our human nature may not change just because we were able to bail ourselves out.
“Unfortunately, refinancing does not bring with it an automatic dose of financial prudence,” said Investopedia. “In reality, a large percentage of people who once generated high-interest debt on credit cards, cars and other purchases will simply do it again after the mortgage refinancing gives them the available credit to do so. The possible result is an endless perpetuation of the debt cycle and eventual bankruptcy.”
2. Because your credit has declined
A refi requires lender approval, which means your credit will be checked. If you know those delinquent credit accounts and overdue car payments have killed your credit score, you might want to wait. Get your free credit report to check your score and ask your lender for options. They might recommend a credit repair program or a streamline refi if you are eligible.
A lower interest rate means a lower payment, which means you’re saving money…right? Not necessarily.
“One of the most important details you need to pay attention to when you’re planning to refinance is the break-even point. This is the amount of time it will take for you to recover the closing costs on the new loan. The break-even point is calculated based on how much you pay in closing costs and what your new interest rate will be,” said smartasset. “If you’re planning on moving before the break-even period ends, refinancing probably doesn’t make much sense since you won’t be reaping any significant financial benefits in the long run. Typically, closing costs average between 2 and 5 percent so it could take several years for you to get back to even. For example, if you pay $3,000 in closing costs and your payment only drops by $50 a month, it’ll take 60 months before you break even.”
4. Because it adds years to your mortgage
If you dream of nothing more than paying off your house and being free and clear, refinancing won’t get you there since it typically adds to the length of your loan (The exception is if you’re refinancing into a shorter term.).
“Increasing the number of years that you owe on your mortgage is rarely a smart financial decision,” said Investopedia. “A savvy homeowner is always looking for ways to reduce debt, build equity, save money and eliminate that mortgage payment. Taking cash out of your equity when you refinance doesn’t help you achieve any of those goals.”