Refinancing your home might seem like a great idea. You hear you can save money and/or lower your rate. What do you have to lose? Unfortunately, there is plenty at risk. Before you jump in and refinance, understand the most common traps. Refinancing isn’t always the best idea. Avoid these common issues and you can protect one of the largest investments in your life.
Using All of Your Equity
You have equity so you want to use it. Who wouldn’t? But should you? The real estate industry is volatile. If you take more than 80-85% of your home’s value out, you leave yourself vulnerable. What happens if values drop? Suddenly, you could find yourself upside down on your home. Instead, focus on the reason you need the cash. Budget the amount you need and only take out that amount. Leave the rest of the equity untouched. If values appreciate, you see a good return on your investment. If they drop, you have protection.
Wrapping Debts Into Your Loan
Excess equity can mean you have money to pay off other debts. Maybe you feel like you are in over your head in debt. Maybe you just hate making multiple payments each month. The thought of wrapping everything into one loan can be enticing. However, it’s not always the right choice. Let’s take a student loan for example. Let’s say you have 5 years left on it. The interest is high, but you have made a dent in the debt already. If you wrap it into a new 30-year loan, you don’t pay that student loan off for another 30 years. This means paying much more interest since you borrow the money for a longer time. In the end, the debt costs you much more.
If you find you can’t afford your debts and must refinance, try the following:
- Pay more than the minimum payment on the mortgage.
- Figure out how much you should pay to pay off the debts you wrap into the loan in their regular term.
This gives you the best of both worlds – you lower your interest and consolidate your debts. Just paying the minimum, though, leaves you in more debt than you were before.
Extending the Term
Again, this trap involves your payment. You get lured in with a lower payment. What you don’t realize is you pay more in the end. A longer term means you borrow the money for a longer period. This means more interest. You will realize smaller monthly payments, but you pay them for a longer period. In order to find out what the loan actually costs, look at your Loan Estimate. It will break down the interest over the life of the loan and the total cost of the loan. This should help you make the right choice for your situation. Again, you have the option to make larger payments. You aren’t restricted to the minimum required. But, if you aren’t consistent with those extra payments, paying more interest is inevitable.
Paying High Upfront Fees
Some lenders offer one fee upfront. They call it the origination fee. When you look at the Loan Estimate, you don’t see a breakdown of things like:
- Credit report
You think the lender is giving you a deal. However, the fee may be even higher than you thought if they charge an origination fee. This is a percentage of your loan amount. Let’s say you borrow $125,000 and the lender charges 3 points. That’s $3,750. You might not have paid that much if the lender itemized the costs. It pays to compare the offers from different lenders. You can even ask the same lender for a quote without the points. This allows you to compare the offers. Don’t focus on the interest rate alone. The lender may tell you they’ll have to charge a higher interest rate. That’s okay. Compare the big picture to find the most affordable loan.
Don’t jump at the chance to save a few dollars. It might sound enticing, but it’s not ideal. Let’s say you can refinance your debts into your home equity loan. You might save $50 a month. But how long will it take you to recoup the closing costs? If the loan costs you $3,000 to close, you wouldn’t see those savings for 60 months or 5 years. Is it worth it? Will you be in the home in 5 years? Again, don’t focus on the short-term, look at the big picture to find the best deal.
Refinancing for a Lower Interest Rate
We all fall for this trap. We hear rates dropped and we think we should refinance. This isn’t necessarily true. You might only save a few dollars. Again, if you pay closing fees, it will take you longer to recoup the fees. Worse yet, if you wrap the fees into your loan, you pay even more interest in the end. The lower rate probably won’t save you anything once it’s all said and done.
Only refinance if you know there is a significant savings. Also, only refinance if you plan to stay in the home. It doesn’t work to your benefit if you will move anytime soon. Usually, 5 years is a good benchmark, but each situation differs.
Refinancing can be a good thing. It can save you money. It may even get you out of debt. But you must know all of the details. If you don’t pay attention to the rate, closing fees, and breakeven point, you might not benefit from the refinance. These traps are the most common issues people fall for. They end up regretting their decision to refinance. If you have a payment you can afford and are unsure of how long you’ll stay in the home, you may be best off keeping your mortgage. Unless you are in over your head in debt and can’t make your minimum payments, try getting out of debt on your own. Refinance only when you know you’ll save money and can pay minimal closing costs with cash out of your pocket.