Refinancing your mortgage into a lower interest rate, lower monthly payment, or other more favorable terms sounds wonderful. If you qualify, it could save you significant money over the life of the loan or ease your burden on a monthly basis. But before you charge headlong into the process, be aware that there can be some not-so-rosy aspects to refinancing.
Fees
The normal range of fees for a refinance is 3-6% of the amount you are refinancing. Once you have a grasp on the fees involved, calculate how long it will take you to recoup that money through your refinance savings. A refinance calculator can help with crunching the numbers. If the number of years before real savings are realized is measured in decades, it probably isn’t worth it to do the refi.
An oft-quoted “rule of thumb” is that at normal refinance fee levels, you will need to save at least 1% off your current mortgage interest rate to make the refinance worthwhile money-wise.
Prepayment penalties
One expense area that is often overlooked by those who refinance is prepayment penalties. When you refinance your mortgage, you are essentially having a lender “pay off” your initial mortgage. When calculating what it will cost to execute the refinance, be sure to include any prepayment penalties in your assessment. These can normally be found in the Truth in Lending statement from your mortgage lender.
Riskier loan
Normally, refinance loans are recourse loans. This means that if you fail to make payments and are forced to sell the home, you need to be able to cover the amount owed on the loan or the lender can seize other assets of yours. If your current mortgage is a non-recourse loan, you take on additional risk by turning it into a recourse product.
PMI
Because of the constantly changing housing market, you could refinance your home at a time when your equity position (how much you owe on the mortgage vs. what the home is worth) falls below 20%. If this is the case, you will need to pay private mortgage insurance (PMI) on the new loan. This is an added expense that would need to be factored into your decision if this applied to your situation.
Less freedom
Once you refinance, you enter into a phase of trying to make back in lower interest the money you spent in fees. It can take a few years to recoup this money. If you need to sell the home during this period, you actually lose money on the deal. This may lead you to feel like you are “chained” to your home.
Despite the possibility for big savings, a refinance isn’t to be entered into lightly. Shop around and read refinance good faith estimates from lenders to make sure you understand all the terms.
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