How to Tell When Refinancing Makes Sense
You might save money, but you might make things worse
Refinancing a loan is a major move that can result in significant savings. But the strategy can also backfire, leaving you in a worse situation than you were in before—and with less money in the bank. So 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 any new problems for you.
Refinance to Save Money
Why would you ever want to refinance? You can potentially save a lot of money, and that’s generally the best reason to refinance.
In particular, refinancing may allow you to spend less in interest over the life of your loan. There are several ways to reduce interest costs:
Fortunately, there’s a way to determine whether you’ll save money: Run the numbers. It’s not especially hard to calculate the potential savings of refinancing. However, while reducing your total lifetime interest costs is wise, refinancing with that goal is not always the right choice.
Shifting debt. The third strategy listed above—consolidating high-interest-rate debt—is somewhat questionable. If you refinance unsecured debts with a secured loan, you’re taking additional 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. If you default on credit card debt, it’s unlikely that the credit card company can foreclose on your home. But once you pledge your home as collateral by using a mortgage loan, your home is fair game.
Lower payments. A lower payment is often used as a justification for refinancing. While it may be nice to pay less each month, make sure to 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, use an amortization chart that shows how much interest you pay with each monthly payment. On a brand-new long-term loan, the payments in early years only make a small dent in your loan balance.
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?
Reduce risk. 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 significant interest rate increases in the future, refinancing into a fixed-rate mortgage will give you more certainty—even though today’s monthly payment (and interest rate) is higher. Evaluate current rates on fixed-rate mortgages, your expectations for rate changes, and the potential for your existing ARM to change.
Debt detox. You might also take cash out to consolidate high-interest-rate debts, but remember that you may end up taking on more risk than you previously had. That said, if you have a solid plan to eliminate toxic debts, the strategy could work. If the plan fails, you may face the risk of losing your home in foreclosure or having your vehicle repossessed.
Investing in your future. Some homeowners use cash-out refinancing to pay for education, home improvements, or starting a business. While those uses are better than paying for expensive vacations or ongoing consumption, the strategy can put you in a worse position than you were in originally.
What to Watch Out For
If you’re thinking it’s time to refinance, investigate the following:
- Closing costs. Those costs will add to the expense of your loan, and they may wipe out any gains from lowering your interest rate. It’s tempting to roll those costs into the loan balance, but it may be better to pay out of pocket.
- Prepayment penalties on the loan you will refinance into.
- If your home has lost value, will you need to add private mortgage insurance (PMI)?
- If you refinance, you may turn a nonrecourse loan into recourse debt. If you do that, you may open up the risk of your new lender garnishing your wages and taking other action against you if you go through foreclosure.
- Home equity may change. If you take cash out or add significant closing costs to your loan balance, you’ll reduce your share of equity in your property. However, if you just replace one loan with another loan of the same size, your equity remains the same.
Before refinancing, do a basic breakeven analysis. You’ll probably have to pay closing costs, so you need to figure out precisely 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
Sometimes refinancing isn’t your best option—or it’s just not feasible.
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.