There are many good reasons to refinance, but along with that, there are also at least four terrible reasons to refinance your home. For example:
- Cash out for a spending spree
- Skip a monthly payment
- Improve short-term cash flow
- Everyone else is doing it
These bad reasons to refinance all have something in common: a short-term focus. But we’ll also talk about how short-term circumstances are sometimes shaky enough that you can’t think too much about the long term and you might just want to go ahead and refinance if it will help you get through a rough patch.
1. Cash Out for a Spending Spree
What constitutes a spending spree can be a matter of opinion. Is a cash-out refinance that funds the vacation of a lifetime a risky spending spree? Or is it a smart way to leverage your biggest asset to seize the day while you’re feeling healthy and energetic enough to make the trip? What’s worth it to you may not be worth it to your neighbor.
We would not, however, recommend frittering away your home equity on assorted restaurant meals, cable bills or wardrobe additions. This is a bad way to handle the proceeds of a refinance.
2. Skip a Monthly Payment
Direct-mail advertisements about how you can skip a monthly payment by refinancing are how bottom-feeding lenders try to sucker uninformed consumers into buying new mortgages.
They promise that, from the date you close until the first of the next month, you will not have to make a monthly mortgage payment. However, the interest will be one of the closing costs in your new loan, and you’re basically just pushing the skipped payment to the end of your new mortgage term.
Since these ads are geared toward the cash-strapped homeowner, they may also advertise that you can refinance for “free,” with no cash out of pocket. But you’ll either pay for your refinance in the form of a higher interest rate (to compensate the lender for paying your closing costs) or a higher loan balance (by rolling the closing costs into your new loan). This no-cost refinance may bring temporary relief but can be costly in the long run.
3. Improve Short-Term Cash Flow
Skipping a monthly payment may be the most short-sighted of all reasons to refinance, but improving your short-term cash flow is a close runner up. Refinancing into a longer term at a similar or lower rate than you’re currently paying will lower your monthly payment. The closing costs and the extra interest you’ll pay in the long run might make you regret your decision in a few years.
If your credit is good enough to get a new mortgage, then it’s good enough to get another type of loan that could fix your short-term cash-flow issues. A personal loan with a fixed rate and fixed repayment period could be a good solution. The interest rate will be higher, but the total cost likely will be lower because the loan term will be shorter.
Life circumstances such as unexpected medical bills or other expenses might require you to explore the short-term benefits of refinancing even if it doesn’t maximize your long-term savings, especially if a personal loan can’t provide the cash you need. But if you’re able to focus on the long term, you might get a better result.
4. Follow the Herd
Even if mortgage rates are at record lows, you shouldn’t automatically refinance.
Let’s say you’re about five years in on your $300,000, 15-year fixed-rate mortgage and you owe about $214,000. Refinancing into a new 15-year loan would lower your interest rate from 2.875% to 2.375%, which would lower your monthly payment by about $640 (from $2,053.76 to $1,414.15).
You’ve paid about $37,000 in interest over the last five years, and if you start over with a new 15-year loan, you’ll pay another $41,000 in interest over the next 15 years, for a total of $78,000. You’ll also incur a few thousand dollars in closing costs.
If you stick with your current loan, you’ll pay another $32,000 in interest over the next 10 years for a total of $69,000. It’s the cheaper option.
If you refinanced into a 10-year loan, you’d pay about $27,000 in interest over the life of the new loan. If closing costs are $5,000—a reasonable estimate since these fees typically total 2% to 5% of the loan amount—you’ll only break even by refinancing.