A mortgage refinance can have clear financial benefits. Replacing your current mortgage with a new one could lower your interest rate or monthly payment, help you change between a fixed-rate and adjustable-rate mortgage, allow you to borrow some of your home’s equity, or let you extend your loan or pay it off more quickly.
But as with any major financial move, there are risks. Before making a decision, homeowners should ask themselves: Is refinancing bad for someone in my financial situation?
Here are some caveats to consider when deciding whether refinancing is the right move.
Consolidating debts with a cash-out refinance might seem like a win-win situation. You pay off your existing mortgage with a new one that’s based on your home’s current value, allowing you to pocket the difference as cash that you can use to pay off debts such as credit card balances, student loans, or medical bills. While your monthly mortgage payment could go up to cover your new loan amount, you may still end up saving money this way, since you would have fewer debts to repay each month at a potentially lower interest rate.
Where it gets tricky is with the loan term. Even though the original debts may be gone, you would be repaying the money you borrowed to consolidate those debts for the full length of your new mortgage. For instance, if you use the money from a cash-out refinance to pay off a car loan that has five years of payments left on it, then you’ll be making payments — including interest — for another 15 or 30 years with your new mortgage, depending on your loan term.
Many homeowners are tempted to refinance to lower their interest rate and monthly payment. But even with a lower interest rate, you could end up paying more in interest overall.
With a rate-and-term refinance, adjusting the loan term will have a big impact on how much interest you’re paying. A longer loan term, for example, may come with a lower monthly payment, but it often results in more total interest charged because you’re repaying the loan over an extended period. Additionally, some lenders charge higher rates for longer terms.
A lower interest rate could also cost you more interest the further along you are in repaying your current loan. Borrowers start out by paying more interest than principal on their mortgage — a proportion that changes incrementally over time. Refinancing restarts that amortization schedule.
If you’re doing a cash-out refinance, then you’ll be increasing the amount you’re borrowing and resetting your loan term — both of which could mean you’ll pay more interest on a larger principal. And if you refinance at the wrong time, you could end up with a higher interest rate than before.
Finally, if your credit score has dropped since you first took out your mortgage, you might not be able to get an interest rate that’s low enough for refinancing to save you money.
Many borrowers refinance to reduce their monthly mortgage payment and fail to consider that paying less each month could end up costing them more because the loan is paid back — with interest — over a longer period of time.
For example, if you are seven years into repaying a 30-year, fixed-rate mortgage for $264,000 at a 3.85% interest rate, and refinance to a new 30-year, fixed-rate mortgage at 3.5% interest, then your monthly payment would drop from $1,238 to $1,017. That saves you $221 a month. But even with the lower rate and reduced monthly payment of your new mortgage, you’ll pay $24,469 more in overall interest compared to your original loan. It also would take you a total of 37 years to repay your mortgage.
The same goes for refinancing to change your loan term. Switching from a 15-year term to a 30-year term could lower your monthly mortgage payment, but you’re going to pay more interest in the long run — even if you manage to secure the same interest rate as before — since your principal has more time for interest to accumulate on it.
That doesn’t necessarily mean you should avoid refinancing, but it’s an important aspect to consider, says Casey Fleming, a loan advisor and author of “The Loan Guide: How To Get the Best Possible Mortgage.” Borrowers could make extra payments on their mortgage after refinancing to compensate for extending the loan term, he says. This could curb some of the interest compounding.
If you need cash for a major expense and have some home equity to work with, then a cash-out refinance could be an option to get those funds. But remember that cash taken out of your home has to be repaid — and it comes with a price.
Here are a few potential downsides to a cash-out refinance:
- Reduced equity: One of the most significant drawbacks is that you end up with less equity, which is the difference between what your home is worth and how much you owe on it. If your mortgage balance is still high when you decide to sell, then you’ll have less cash in your pockets once your loan is repaid with the sale.
- A larger principal to repay: If you refinance and take out cash for another purpose, then your monthly payments and loan term will change to accommodate the higher amount you’ve borrowed. This also means you might end up paying more in interest, since your mortgage rate will compound on the larger principal.
- Possibly higher monthly payments: If your principal increases, then your monthly payment also could increase — even if you receive a lower interest rate.
- Closing costs: The refinancing process is a lot like getting a mortgage in the first place, which means you have to pay refinance closing costs. Since average closing costs on a refinance are about $5,000, that’s a major factor to consider.
- Private mortgage insurance: If you end up with less than 20% equity after refinancing, then you’ll have to pay PMI to protect your lender against losses should you default. PMI costs between $30 and $70 a month for every $100,000 you borrow — which can add up.
- Risk of foreclosure: If you’re struggling to pay your mortgage now, and your monthly payment increases after a cash-out refinance, then you’ll increase the risk of defaulting on your loan and the lender foreclosing on your home.
Like when you’re buying a home, you have to pay closing costs when you’re refinancing a mortgage. Here are a few common closing costs involved in a refinance:
- Appraisal: You likely will need an appraisal to determine how much your home is worth. An appraisal typically costs between $300 and $400.
- Loan origination fee: The lender charges a fee for processing your loan. This usually costs between 0.5% and 1% of the loan amount.
- Title fees: Title search fees involve researching your home in government records to ensure that the title is free from unknown liens or other claims to ownership. The cost averages $200 to $400.
- Discount points: You might be able to buy discount points that allow you reduce the interest rate on your loan. A point costs 1% of the loan amount, and usually reduces your interest rate by 0.25 percentage points.
While you can pay closing costs upfront, some borrowers opt for a no-closing-cost refinance, which is when you roll closing costs into the mortgage. The downside is that you’ll end up with a larger loan balance or a higher interest rate, which could end up costing you more than the original closing costs in the long run.
Another factor to consider outside of closing costs is the prepayment penalty. Some lenders charge a penalty fee if a mortgage is repaid early, so you’ll want to know if your current loan has a prepayment penalty before deciding to refinance.
Because refinancing your mortgage comes with closing costs, it takes time before what you’re saving covers what you’ve spent. The point at which your savings repay the cost of refinancing and you start saving money is known as the break-even point.
To calculate the break-even point, divide your closing costs by how much you’ll save each month. For example, if refinancing will shave $100 off your monthly payment, and your total closing costs are $4,000, it will take you 40 months — or over three years — to break even. The greater your refinance costs, the longer it will take you to reach the break-even point.
If you plan to sell your home before reaching the break-even point, then you’ll lose the money you sunk into taking out a new loan, and it may not make sense to refinance.
If you choose to refinance, you may be surprised at the other potential long-term costs:
- Credit score decrease: Refinancing could hurt your credit score because you’re closing an old account and opening a new one with no payment history, Fleming says. This is compounded if you’re refinancing to consolidate debt, since closing multiple accounts as you pay them off reduces the average length of your credit history. This decrease goes away relatively quickly — usually after a few months — and your score will rebound if you pay your bills on time.
- Higher debt-to-income ratio: If your mortgage payment increases — and your total monthly debt obligation along with it — then your DTI will grow and make it more difficult for you to get approved for other loans.
- Becoming “house-poor”: If you refinance your home and your mortgage payments take up more of your monthly budget, then it could prevent you from having enough cash available for other uses.
- Going underwater on your mortgage: If your home’s value drops below the amount you refinanced it for, then you’ll be underwater on your mortgage. This makes it more difficult to refinance or sell your home, and increases your risk of foreclosure.
If you have an adjustable-rate mortgage and your initial rate lock has expired, then your interest rate will adjust — usually once a year.
Borrowers may be attracted to an ARM vs. a fixed-rate mortgage because an ARM usually has a lower initial interest rate. But in some cases, the borrower might be unable to afford their mortgage if interest rates rise and their monthly payment increases. They could also end up paying more total interest over the life of the ARM compared to a fixed-rate loan, depending on how interest rates fluctuate.
So, is it bad to refinance your home? That’s a question each homeowner must answer for themselves by factoring in their financial situation and their goals. Refinancing, ultimately, is a major decision that needs to be weighed carefully.
When you should refinance
Here are some conditions that could suggest a good time to refinance:
- If your credit has significantly improved. If you had a major negative mark fall off your credit report, then you might be able to get a lower interest rate.
- If interest rates have dropped. Low interest rates mean you could get a better rate on a new loan now compared to when you first bought your home — potentially saving you money in the long run.
- If your home’s value has greatly increased. If your home has appreciated, refinancing could help you remove PMI from your monthly mortgage payment. This could save qualified homeowners up to hundreds of dollars each year.
- If you plan on staying in the home for some time. If you sell or refinance before you hit the break-even point, then you could end up losing money to closing costs. Generally, the longer you stay, the more you save.
Refinancing your mortgage isn’t a decision to be made lightly. Current interest rates, your financial situation, and other factors can all influence whether refinancing is worth it.
In ideal circumstances — and done correctly — refinancing could save qualified homeowners up to thousands of dollars in interest over the lifetime of their loan. But if you plan to move soon, already have a low interest rate, or are considering a major lifestyle change, you may want to reconsider. Either way, do the math and make sure you’ll save money with a refinance — or you’ll end up paying more than you save.