Refinancing a mortgage means paying off an existing loan and replacing it with a new one. There are many reasons why homeowners refinance: the opportunity to obtain a lower interest rate; the chance to shorten the term of their mortgage; the desire to convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, or vice versa; the opportunity to tap a home's equity in order to finance a large purchase; and the desire to consolidate debt.
Converting Between Adjustable-Rate and Fixed-Rate Mortgages
While ARMs often start out offering lower rates than fixed-rate mortgages, periodic adjustments can result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to a fixed-rate mortgage results in a lower interest rate and eliminates concern over future interest-rate hikes.
Tapping Equity and Consolidating Debt
While the previously mentioned reasons to refinance are all financially sound, mortgage refinancing can be a slippery slope to never-ending debt. It's important to keep this in mind when considering refinancing for the purpose of tapping into home equity or consolidating debt.
Homeowners often access the equity in their homes to cover major expenses, such as the costs of home remodeling or a child's college education. These homeowners may justify such refinancing by pointing out that remodeling adds value to the home or that the interest rate on the mortgage loan is less than the rate on money borrowed from another source. Another justification is that the interest on mortgages is tax deductible (although the 2017 tax law has reined this in for both existing and new mortgages). While these arguments may be true, increasing the number of years that you owe on your mortgage is rarely a smart financial decision, nor is spending a dollar on interest to get a 30-cent tax deduction.
Many homeowners refinance to consolidate their debt. At face value, replacing high-interest debt with a low-interest mortgage is a good idea. Unfortunately, refinancing does not bring with it an automatic dose of financial prudence. Take this step only if you are convinced you'll be able to resist the temptation to spend once the refinancing gets you out from under debt. Be aware that a large percentage of people who once generated high-interest debt on credit cards, cars and other purchases will simply do it again after the mortgage refinancing gives them the available credit to do so. This creates an instant quadruple loss composed of wasted fees on the refinancing, lost equity in the house, additional years of increased interest payments on the new mortgage, and the return of high-interest debt once the credit cards are maxed out again – the possible result is an endless perpetuation of the debt cycle and eventual bankruptcy.
The Bottom Line
Refinancing can be a great financial move if it reduces your mortgage payment, shortens the term of your loan or helps you build equity more quickly. When used carefully, it can also be a valuable tool in getting debt under control. Before you refinance, take a careful look at your financial situation and ask yourself: How long do I plan to continue living in the house? And how much money will I save by refinancing?
Again, keep in mind that refinancing costs 3% to 6% of the loan's principal. It takes years to recoup that cost with the savings generated by a lower interest rate or a shorter term. So, if you are not planning to stay in the home for more than a few years, the cost of refinancing may negate any of the potential savings. It also pays to remember that a savvy homeowner is always looking for ways to reduce debt, build equity, save money and eliminate that mortgage payment. Taking cash out of your equity when you refinance doesn't help you achieve any of those goals.
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