You hear interest rates dropped so you assume you should refinance, right? Not so fast. Refinancing is risky for some. For others, it’s a great thing to do. How do you know if it’s right for you or not? You need to know the traps.
We list them for you below.
Don’t Use up All of Your Equity
Don’t get us wrong, we know it can be exciting to learn that you have thousands of dollars of equity in your home. But, we caution you on using it. Don’t look at the dollar amount. Instead, look at the percentage or your LTV (loan-to-value ratio). How much equity do you have based on the home’s current value.
Is it close to 80%? If so, you may not want to refinance yet. Most loan programs only allow you to tap into up to 80% of the home’s value. If you need to take cash out of your home, wait until you have more equity. Real estate values are volatile. One day they could be high and a few months later, you could find that your home is worth thousands less than before. Don’t put yourself at risk of getting in over your head. Only take out the equity that will keep you well below that 80% benchmark.
Lengthening Your Term
Who doesn’t love hearing that they can have a lower mortgage payment? We all want that, but if it comes at the expense of a longer term, it’s not all that it’s cracked up to be. The longer you borrow money, the more interest that you’ll pay.
Even if you don’t take a longer term than you have now, you could still unknowingly extend your term. Here’s an example:
You currently have a 30-year mortgage. You’ve paid on it for 10 years. You heard interest rates dropped and you want to take advantage so you refinance into another 30-year term. You just extended your term another 10 years. In other words, you lost the 10 years of payments you already made. Instead, see what you can do to get a term that closely matches the time you have left on your term (in this case a 20-year term).
Paying off Consumer Debt
Credit card interest rates can skyrocket, making it seem impossible to get out of debt. If you have the equity in your home, you may consider wrapping your debt into your mortgage. It’s not a bad idea, but only if you avoid these traps:
- Don’t use your credit cards again – If you pay off your credit cards with your mortgage only to rack up the credit card debt again, you’ll find yourself in an even worse position. You’ll have double the debt. Instead, lock your credit cards up and don’t use them. If you can’t trust yourself not to use them, don’t wrap the debt into your mortgage.
- Paying only the minimum payment – If you wrap your consumer debt into a 30-year mortgage, you’ll pay interest on the debt for the next 30 years. That could end up costing more than what you’d pay on the credit cards. Try making more than the minimum payment to get the balance paid down faster.
- Borrowing more than 80% of the home’s value – If you find a loan that allows up to an 85% LTV, you may end up paying mortgage insurance on the loan just to pay off your consumer debt. Look at the bottom line. Does it make sense to do this or will the new loan cost you more every month? If you use government financing, you’ll pay mortgage insurance for the life of the loan, think about it carefully.
Paying too Many Closing Costs
Every mortgage has closing costs. Consider the cost of refinancing in addition to the interest rate. If you focus only on the interest rate, you may miss the fact that you are overpaying for the loan itself. One of the best ways to figure this out is with the break-even point.
First, figure out how much you’ll save each month with the new loan. Compare the total mortgage payments to get the total savings. Next, determine the total closing costs. With these two numbers, you can figure out your break-even point with the following calculation:
Total closing costs/Monthly Savings = Months to Break-Even
For example, if you can save $150 per month, but the refinance will cost you $4,000, your break-even point would be:
$4,000/$150 = 27 months
Now, think about your plans. Will you be in the home for at least 3 years? If not, refinancing won’t make sense. Even if you’ll be in the home for 4 or 5 years, consider if the savings are enough. You don’t start reaping the savings until you pay off the closing costs.
This can help you put into perspective whether or not it makes sense to refinance. Even with low closing costs, sometimes the monthly savings just aren’t enough to justify refinancing. Make sure you’ll truly save enough to make it worth it.
Refinancing can be a great way to save money or tap into your home’s equity, but it doesn’t always make sense to do so. Really evaluate the numbers. Decide if it makes sense to pay the costs to refinance the loan. Will you save enough money? Will you use your equity wisely? Avoid the most common refinancing traps to make sure that it makes sense for you.