Mortgage interest rates are at historic lows, but does that mean you should refinance an existing mortgage? A “refi” may pay off, but you should consider all of the relevant factors, including these five potential problems:
1. You’re back to square one. Starting over is hard to do if you’re close to paying off a mortgage. For instance, if you take out a 30-year loan, the monthly payments in the first seven years will reduce your principal by only 5% or so, with the rest going to interest. Instead of beginning to make a dent in their principal debt, homeowners who refinance after seven years are effectively starting from scratch. Figure out how much you’re really saving if you shave only a percentage point or less off your current rate.
2. Closing costs can pile up. Depending on how long you stay in a home, the expenses of a new loan can outpace the savings. Figure on closing costs equal to about 1.5% of the mortgage amount. Then calculate your monthly savings to see how long it will take you to break even on the cost of the mortgage. For example, if you refinance a $300,000 mortgage, closing costs will run about $4,500. If the new mortgage interest rate is 1 percentage point lower than your current rate, you will save $178 a month and will need just over 25 months to recoup your closing costs. So if you’re not planning to stay in the house for more than two years, you could end up losing money. Reduce these costs by paying the prepaid items out of pocket. You’ll get that money back when the escrow accounts on your old loan are paid back to you.
3. Terms can be confusing. With refis so popular now, they can take a long time to process, and it may not be clear when you should stop paying your current mortgage. If you inadvertently fall behind, it could throw a monkey wrench into the works. Generally, lenders offer a two-week grace period after a mortgage payment is due and then charge a 5% penalty. Even worse, your credit score might plummet by 100 points or more if you’re 30 days past due—and that change could affect your refi.
4. The appraisal may be too low. Before the refi is approved, the lender will require an independent appraisal to confirm the home’s value. The numbers now are trending lower than expected for many homeowners, especially those who reside in areas hit by numerous foreclosures. If the appraised value is too low and you don’t have enough equity in the home, the lender could raise the rate or deny the loan altogether.
5. You could pay hidden fees. Under federal law, lenders must provide a good-faith estimate of the fees needed to complete the refi, and that statement could reveal costs you hadn’t expected. Also, some low-interest mortgages require you to pay “points,” and each point is equal to 1% of the mortgage amount. That could delay your break-even point even longer.