Should You Ever Consider Mortgage Refinancing?
Using your money wisely is what Finance Guru is all about. Mortgage refinancing cuts right to the core of the issue, because it can be a profoundly wise move or a stupendously unwise one. It all depends on you. If you refinance responsibly, you can save interest expense and possibly get out of debt sooner.
However, if you use the refinancing benefit imprudently, you can find yourself in a perpetual cycle of debt that can lead to financial ruin. Read on to learn when refinancing makes sense and when it’s not the right solution.
The Advantages of Mortgage Refinancing
When you refinance a mortgage, you take out a new mortgage loan and use all or most of it to repay the existing mortgage. The transaction involves fees costing you 3% to 6% of the new mortgage amount. The new mortgage can have different terms, including interest rate, length and whether it charges fixed or variable interest. We discuss four scenarios under which refinancing could make sense. However, we’ll review the dark side of mortgage refinancing, and how it could forever dominate your destiny.
1. Lower Interest Rates
This is probably the most compelling reason to refinance a mortgage. Paying less in interest means having more money for other, hopefully responsibly-chosen, purposes. Most experts set a threshold of a 1% to 2% point interest rate drop to make refinancing worthwhile. A lower interest rate also means you will build equity in your home faster and can lower your monthly payments.
Let’s look at an example. Suppose you currently have an 7% fixed-rate, 30-year mortgage. The original balance was $350,000, but now, after 10 years, the remaining balance is $214,531 You can refinance the mortgage with a 5%, 30-year loan carrying a 4.5% upfront fee ($9,654). Using any one of the online refinance calculators, you determine that your monthly payments will drop from $1,663 to $1,152, a savings of $511/month and $42,975 over the life of the loan. It will take you ($9,654 / $511), or almost 19 months, for the savings to pay for the upfront fee. This will reduce your net savings to $33,321 over the full mortgage term.
In this example, your pretax savings are substantial. If you plan to sell your home in seven years, the total benefit will be $7,398. As long as you don’t sell the property within the next 19 months, you will come out ahead, even after fees.
2. Reduced Mortgage Term
In this scenario, you apply your interest savings to reduce the term of the mortgage, allowing you to emerge from debt sooner.
We take the same facts from the previous example, except the new mortgage has a 15-year term. You have 20 years remaining on the original mortgage, so refinancing will retire your mortgage debt 5 years sooner. Your monthly payment will actually increase by $33, but because the term is shorter, you’ll save $37,924 over the new loan term. After fees, your net pretax savings are $28,270.
3. Switching Between Fixed and Variable Rates
It might make sense to switch from a variable-rate mortgage to a fixed-rate one if you think interest rates are heading higher by at least 1% to 2% points. This way, you lock in the current prevailing rate and protect against future rate hikes. Conversely, if you predict a similar drop in rates, you might want to convert your fixed-rate mortgage to a variable-rate one, so that you can enjoy the benefits of lower interest rates without multiple refinancings.
This scenario might work out if your rate prediction is correct and the rates move sufficiently to make refinancing worthwhile after fees. Switching from fixed to variable can be beneficial if you don’t plan to remain in the house for more than a few more years. That way you don’t risk interest rates rebounding.
4. Cashing Out Equity
You can choose cash-out refinancing to increase your loan balance beyond the amount needed to repay the existing mortgage. You take the surplus amount in cash that you can use for any purpose you like. Of course, this reduces your home equity and extends the loan term. What you do with the proceeds will largely determine whether this transaction makes sense, as we discuss next.
Disadvantages of Refinancing
Refinancing can be a bad idea if you use it as an opportunity to get into further debt. This is most evident when you take a cash-out refi. It might seem like a good idea if you use the money to consolidate other debt or to pay for remodeling your home. The problem is that a cash-out extends your period of indebtedness. If you make a habit of it, you’ll never pay off your mortgage, creating a permanent debt spiral.
Some folks justify a cash-out because mortgage interest is tax-deductible (for mortgage debt up to $750,000). However, that doesn’t hold water because you’ll be spending $1 in interest to get $0.25 in tax deductions (assuming the 25% bracket).
Using a cash-out to refinance current debt can make sense, as can lowering your monthly mortgage payment. However, this only works if you control your spending. If you re-establish debt after paying it off, you might be in a worse situation than before you refinanced. Each time you refinance, you’ll be spending money on closing fees that’ll take you years to recoup. This locks you into your home for at least as long necessary to receive payback on the fees.
In sum, if you run up debt after refinancing your home, the resulting ill effects can include:
Reduced equity in your home
Additional years of mortgage
Possible return of high-interest debt if you once again max out your credit cards after consolidating them
Mortgage refinance can make good sense if it lowers your mortgage payment, allows you to build equity faster or shortens your loan term. If applied carefully, you can use the debt savings to control your current and future debt. The benefit is smaller if you don’t plan to remain in your home much longer, or if the amount you save through refinancing isn’t all that much. If you use the savings or cash-out to increase your debt, you might find yourself on the road to bankruptcy. Weigh all these considerations and proceed only if you feel that refinancing makes sense in your situation.