When to Refinance a Mortgage (and When Not To)
Refinancing your home by replacing your previous mortgage with a new one can seem like a foolproof way to save money, or an instant salvation to your financial woes. But how can you REALLY tell when to refinance, and when to stay put? Here are some honest questions to ask yourself before you proceed.
What will you save by refinancing?
One common goal of refinancing is to reduce your monthly payment. While this could ease your household expenses, you may end up paying more in interest long-term if the length of your loan is extended.
Alternately, your monthly payment could increase or remain the same, but you’ll still reduce your overall interest costs over the length of the loan. This happens when you refinance from a 30-year mortgage to a 15-year mortgage.
In the best-case scenario, you’ll reduce your monthly payment AND interest costs. This occurs when you refinance at a lower interest rate without extending your loan, or switch to a shorter loan term after you’ve paid a significant portion of your previous loan.
How long do you plan on being in your home?
If you’re considering when to refinance, envision any upcoming needs to relocate such as moving for work or to be closer to relatives. In most cases, a refinance only makes sense if you’re planning on staying in your home for several more years. This is due to the breakeven point.
Your breakeven point tells you how long it will take before your refinance actually starts saving you money. It accounts for all the costs of attaining a new loan. If you’re planning on moving before your breakeven point occurs, the refinance is probably not a smart financial decision.
Does it make sense to change your loan type?
Often, borrowers will opt to refinance an adjustable-rate mortgage (ARM). ARMs have a bit of a bad reputation, but economic conditions do commonly favor this loan type.
First, take a look at market forecasts. While not always accurate, you can use them to assess whether your ARM is likely to continue to work out in your favor. If you have an ARM that you know is due to reset at a higher interest rate, it may be wise to consider switching to a fixed-rate mortgage.
On the contrary, If you have a fixed-rate mortgage and you know you’ll be moving very soon, switching to an ARM might make sense because lenders offer lower interest rates on ARM loans. You can reap the short-term savings of an ARM without the long-term risks (again, check your breakeven point).
What are the long-term costs?
Some refinance terms, such as a reduced interest rate without an extended loan length, are a win-win. Others may come back to haunt you in the future, such as an extended loan without an interest rate reduction.
A little breathing room in the budget can be tempting—maybe even enough to consider resetting your loan back to a 30-year mortgage to lower your monthly payment. Along with adding YEARS of repayment, you’ll be stuck with thousands more in interest. Proceed with caution and keep your eye on the future.
Are you at risk of speeding up the debt treadmill?
Borrowers frequently refinance in order to withdraw their equity in cash to consolidate debt, invest, or remodel. At the surface, this seems like a solid plan. The problem is that we are humans, and cash is very easy to spend. Eventually, that cold hard cash is likely to turn into more debt as it is used to secure other loans.
Additionally, credit cards are unsecured debt, meaning if you default on a credit card loan, you won’t lose a major asset like your home. It is risky to transfer that debt to an asset-backed mortgage loan. Consider these risks if you’re aiming to reduce credit card debt using your home equity.
In all cases, it’s important to know: what is refinancing going to do to my long-term financial picture, and will it help me meet my goals? Refinancing can set you up for success or increased hardship. An honest look at your motives (and a chat with a trusted financial advisor) can help you understand your options.
- Hal M. Bundrick (Feb 2017) If You Refinance a Mortgage, When Will You Break Even?
- Miranda Marquit (May 2013) Fixed or Adjustable? Choosing the Right Mortgage Loan.
- James Chen (Aug 2019) Unsecured Loan.