How to tell when refinancing loan 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 before – and with less money in the bank. So how do you know if you should refinance? The short answer is that it should be done if you end up saving money and if it will not cause new problems.
Refinancing saving money
Why would you ever want to refinance?
You can potentially save a lot of money, which is generally the best reason to refinance.
In particular, refinancing can allow you to spend less in interest over the life of your loan. There are several ways to reduce interest costs:
- Refinance to a lower interest rate so you pay less on your loan.
- Switch to a shorter loan term, even if it means higher monthly payments, so you pay interest for fewer years.
- Consolidate high interest debt to lower interest debt.
Fortunately, there is a way to determine if you will save money: Run the numbers. It is not particularly difficult to calculate the potential refinancing savings. However, while reducing life expectancy, interest costs are wise, refinancing to that end is not always the right choice.
Changing debt. The third strategy, cited above high interest rate debt consolidation – is somewhat questionable. If you refinance unsecured debt with a secured loan, you take on additional risk.
For example, you might use a home equity loan to pay off credit card debt. Yes, you paid off a debt with a lower interest rate, but you also put your home at risk. If you are in charge of credit card debt, it is unlikely that a credit card company will be able to block your home. But when you lease your home as collateral using a mortgage loan, your home is fair game.
Lower payments. Lower payments are often used to justify refinancing. While it might 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 are only 15, for example) can increase the total amount of interest you pay over your lifetime. To understand why, use a depreciation chart that shows how much interest you pay with each monthly payment. On a whole new long-term loan, making payments in the early years only diminishes your borrowing.
Changing to an Adjustable Rate Mortgage (ARM) is another way to reduce your payment. However, interest rates on these loans may increase and your payment may one day rise to an unavailable level. You should only refinance in ARM if you are willing and able to risk higher monthly payments on the way.
Other reasons for refinancing
You already know you need to refinance when you can save money, but what about other strategies?
Reduce your risk. Refinancing might be a good idea even if you don’t get a lower rate or short-term loan in some cases. For example, you could refinance to exit the ARM. If you are concerned about significant interest rate increases in the future, refinancing into a fixed rate mortgage gives you more security – although today’s monthly payment (and interest rate) is higher.
Evaluate your current fixed rate mortgage rates, your expectations for changing course, and the potential for changing your existing ARM.
Debt Detox. You can also take money to consolidate high interest rate debt, but remember that you may have more risk than you previously had. That said, if you have a solid plan for getting rid of toxic debt, the strategy could work. If the plan fails, you may run the risk of losing your home in detention or having your vehicle recalled.
Investing in your future. Some homeowners use cash refinancing to pay for education, home improvements, or starting a business. While these are better than paying for expensive vacations or current spending, the strategy can put you in a worse position than you were in the original.
What to watch for?
If you think it’s time to refinance, research the following:
- Closing costs. These costs will increase the cost of your loan, and they can wipe out any gains from the interest rate cut. It’s tempting to put those costs into the balance of the loan, but it might be better to pay out of pocket.
- Penalties for repaying the loan to which you will refinance.
- If your home has lost value, do you need to add Private Insurance?
- If you refinance, you can convert the real estate loan into recourse debt. If you do this, you may open the risk of a new lender paying you and taking other actions against you if you go through the write-off.
- Home equity can change. If you take money or add significant closing costs to your loan balance, you reduce your equity stake in your property. However, if you only replace one loan with another loan of the same size, your capital will remain the same.
Before refinancing, do a basic fracture analysis. You will probably have to pay closing costs, so you need to understand exactly how and when you will offset those costs and how it will affect your finances. Remember that if you do not pay the closing costs, you will end up with a higher interest rate.