Should You Refinance?

When to do it, When to Avoid Refinancing

Run the Numbers
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Refinancing a mortgage (or any loan) is a major move. It can result in major savings or major headaches. How do you know if you should refinance? The short answer is that you should do it if you’ll end up saving money and if it won’t cause problems. Let’s examine when refinancing makes sense and when it should be avoided.

Refinance to Save Money

Why would you ever want to refinance? You can save a lot of money, and that’s generally the best reason to refinance.

In particular, you can often spend less in interest over the life of your loan. There are a few ways to save on interest costs:

  • Refinance to a lower interest rate
  • Switch to a shorter loan term (even if it means higher monthly payments)
  • Consolidate high-interest-rate debts into lower interest rate debts
How do you know if you’ll save money? Run the numbers. Learn how to calculate savings from a refinance.

In general, you should refinance when you can reduce your total lifetime interest costs. However, the last strategy above (consolidating debts) is questionable. If you refinance unsecured debts with a secured loan, you’re taking a risk. For example, you might use a home equity loan to pay off credit card debt. Yes, you’ll pay off the debt with a lower interest rate, but you’ve also put your home at risk. When you default on credit card debt, it’s unlikely that the credit card company can foreclose on your home.

However, once you pledge your home as collateral (by using a mortgage loan), your home is on the line.

You might also think you should refinance if you can get a lower payment. While it may be nice to pay less each month, make sure you look at the big picture. Extending a loan (starting a new 30 year loan when you only have 15 years left, for example) can increase the total amount of interest you pay over your lifetime.

To understand why, learn how loan amortization works.

Changing to an adjustable rate mortgage (ARM) is another way to lower your payment. However, interest rates on these loans can increase, and your payment may someday rise to a level that’s unaffordable. You should refinance into an ARM only if you’re willing and able to take the risk of higher monthly payments down the road.

Other Reasons to Refinance

You already know that you should refinance when you can save money, but what about other strategies? Refinancing might be a good idea even if you don’t get a lower rate or a shorter term loan in some cases. For example, you might refinance to get out of an ARM. If you’re worried about interest rate increases in the future, refinancing into a fixed rate mortgage will give you more certainty -- even though today’s monthly payment might be higher.

You might also refinance in order to consolidate high-interest-rate debts, but remember that you may end up taking on more risk than it’s worth. Similarly, you can do a cash-out refinancing to pay for education, home improvements, or to start a business. Just remember that if things turn sour, you might lose your home.

What to Watch Out For

If you decide to refinance, be aware of the following:

  • Closing costs. In general, it makes more sense to refinance and pay closing costs if you’re going to keep the loan for the long term
  • Prepayment penalties on the loan you will refinance
  • If your home has lost value, will you need to add private mortgage insurance (PMI)?
  • If you refinance, you may turn a non-recourse loan into recourse debt (meaning your lender can garnish your wages and/or take other action against you -- as opposed to just foreclosing on your home)
In every case, you should only refinance after doing -- at a bare minimum -- a breakeven analysis. You’ll probably have to pay closing costs, so you need to figure out specifically how and when you’ll recoup those costs and how it will affect your finances going forward. Remember that if you don’t pay any closing costs, you’ll end up with a higher interest rate.

Instead of Refinancing

Perhaps you see the logic in refinancing but it’s not possible for some reason.

You can still get some of the benefits of a refinance without going through the process. For example, if you want to save on interest costs, you can pay more than the minimum required each month. You'll get rid of the debt earlier and you'll spend less on interest over your lifetime.