When You Should Refinance, and When You Shouldn’t

Revisiting a home loan and adjusting the terms is something that most homeowners will do at least once during the life of the loan. There are many reasons people choose to do this; some of these are good and some of these are photodune-5339690-home-xsbad. When refinancing your loan you never want to get yourself into a situation where you are increasing your debt or putting yourself in a position where the loan will not be able to be paid off in your lifetime. So with that thought in mind, before you choose to refinance here are some of the reasons why you should, and some of the reasons why you definitely should not.

When it is Smart to Refinance

When you take the steps to alter your loan, you’ll be faced with one of two options. You can choose the cash out option, where you increase the loan amount and take out the equity in the home, or the standard option, which is simply revisiting your loan to adjust the terms. No money is taken out with the standard option, unless it is removed to cover the costs of closing the loan.

So here are a few of the reasons people choose to refinance:

  • Pull out the equity and use it elsewhere
  • Reduce the interest rate of the loan
  • Reduce the monthly mortgage payment
  • Pay off the mortgage faster
  • Consolidate debt
  • Switch from an ARM to a fixed rate mortgage

The list continues but these are some of the common scenarios. As a good rule of thumb if you intend to stay in the home for an extended period of time and you want to reduce your monthly payment, lower your interest rate, pay off the mortgage faster, receive funding for other investments, or switch to a fixed mortgage, you may want to consider refinancing.

Adjusting the terms of the loan is a good way to lower your monthly mortgage payment. Usually this is done by extending the life of the loan back to thirty or forty years, depending on your situation. In some cases people will switch to an ARM loan to reduce the payments as well. Keep in mind that none of these options is without financial risk, so do your homework before you choose to alter the loan.

A more common reason to redo the loan is to lower the interest rate of the mortgage. This is an especially good option right now while the interest rates are low. You may have gotten your mortgage ten years ago when they were a couple of points higher. If you can reduce that rate down to 5% or lower, you can save thousands of dollars over the course of the loan.

For some homeowners, the monthly mortgage payment is not a problem; they just want to reduce the life of the loan. So for these, refinancing to a 15 year mortgage as opposed to a 30 year mortgage is highly tempting. The 15 year mortgage typically has a slightly lower interest rate, but you will have a higher monthly payment. However, you will save thousands of dollars in interest by shaving years off the loan.

The last good reason to refinance is to take the money out and use it to improve your financial situation. This is key; the money needs to be put toward either consolidating your debt or an investment that you know will pay off. This could be updating the home to increase equity, purchasing other real estate, or any number of investments, but in order for this to be a smart financial move it needs to be for an investment.

Use a Calculator to Determine When to Leave your Mortgage Alone

There are times when revamping your loan can be a good financial move, as mentioned above, and there are other times when it can be damaging to your finances overall. We discussed that one of the reasons to consider refinancing is to reduce the monthly mortgage payment, but it needs to be mentioned that this particular path can also be a bad financial move and shouldn’t be done unless you are really in a bind. If you want to reduce the monthly payment so you can have a little more play money, think hard before you do. When you increase the life of the loan you will be paying out more money in interest over time. Unless you reduce the interest rate along with the mortgage payment, you  may end up in a bigger financial bind than you were in before. There are calculators online that can help you determine how much you will save monthly and how much you will spend over the life of the loan. These are worth doing before you decide to lower the mortgage payment.

The other common mistake people make is to cash out the equity in the loan and then put it toward non investment purchases. That vacation or ATV will look tempting at the time, but when you cash out your equity you are increasing the amount of the loan. In the end, the fun you purchased will end up with a far bigger price tag than you had originally intended.

Refinancing your loan is a big financial step, one that can be worked to your advantage or one that can leave you in a bind. Before you decide to take this step, make sure you have a clear picture of why you are doing it and how it will help you in the long run.

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