When you refinance your house, the new loan pays off the existing loan.
The most obvious advantage of refinancing is helping financially strained borrowers to use some of the money from their home’s value to cater to other needs. This is especially helpful when you’re anticipating an increase in your budget.
Other benefits include shortening the term of your mortgage, lowering the interest rate, and in some cases, skipping a mortgage payment while the lender is processing the new loan.
However, refinancing also comes with downsides particularly when you don’t understand what you’re signing up for. Before you decide to go ahead with it, here are the questions you need to ask yourself and the do’s and don’ts that’ll save you from financial pitfalls.
Questions to Consider Before Choosing to Refinance your House
You can avoid unforeseen money issues if you’re careful enough to put yourself on a scale and see whether refinancing your house is a plausible option. Consider the following questions:
1. What Do I Hope to Achieve?
Lower interest rates shouldn’t be the only reason you jump on a refinancing loan. However, it could work if all you want is lower interest rates and reduce your monthly repayments.
According to calculations made by CNBC using the HSH.com calculator, a person servicing a 30-year long mortgage worth $250,000 will have a monthly payment of $1,260.78. This monthly figure drops to $1,147.37 when they refinance. Additionally, they get to save over $34,000 in interest over the thirty-year term.
Alternatively, you could choose to refinance to shorten the term of your loan. It’ll halve the interest rate but your monthly payment will inevitably go up. Also, if you’ve overestimated your ability to pay more for a shorter term, you’ll end up in trouble.
In case your goal is to deal with the uncertainties of an adjustable-rate mortgage, lower interest rates offered by refinancing will work for you.
2. What will Refinancing Cost Me?
According to Investopedia, closing costs generally range between 3 and 6 percent of the purchase price of a home. As an example, if you purchase a $200,000 home, your closing costs could fall between $6,000 and $12,000.
Say your closing costs amount to $3,000 and you get to save $200 monthly by refinancing. It will take 15 months to break even. If you live in the house longer, the refinancing will be worth it.
On the contrary, if you aren’t able to save much -say you only save $50 - it will take you four times as much time to break even. Refinancing would not be very plausible in this case.
Closing costs are also different based on the state, loan type, and lender, so ensure you understand how these costs apply in your situation.
3. Can My Finances Handle the Closing Costs?
Just to be clear, there’s no such thing as no-cost refinancing - in other words, zero closing costs. You end up paying for it one way or another.
The best way to go about closing costs is to ensure you can afford them and to settle them upfront. You could also choose to have them included in your loan if you’re not worried about increasing your repayments.
The last option is to not pay for them upfront but pay higher interest rates - as high as half a percentage point.
The Personal Finances Do’s and Don’ts When Refinancing a House
Now that you know what questions to consider before committing to refinancing a house, here are the do’s and don’ts that’ll ensure you don’t go from the proverbial frying pan into the fire.
- 80% of free credit card reports come with errors. If you don’t check yours for them, it will negatively affect the rates lenders are willing to offer you.
- Determine your breakeven point before applying for refinancing. It will give you an idea of how long it will take you to recoup your refinancing expenses before you can start enjoying a lower mortgage rate.
- Make your refinancing process easier by gathering every relevant piece of your personal financial information.
- Scout for the best refinancing loan terms from different lenders. Just a difference of a fraction of one point of a percentage in interest rates could mean saving or racking up thousands of dollars.
- Get details about locking in your rate as well as rates and float-down provisions. Rates are typically volatile and the rate you began with could change dramatically by the time you’re closing.
- Be wary of repeated refinancing. If interest rates fall by half a point or more, do the calculations to see if the savings surpass the closing costs and other charges tied to refinancing.
- Never refinance into a bigger loan than you need. Because cash out refinancing depletes the equity in your home, you should only go for it if you intend to use the monies wisely.
- Don’t be too trusting about everything your lender says. Do your homework and calculations to understand whether refinancing will only be a short-term relief and make it harder for you later.
- Don’t expect or blindly believe that the bank where you have your checking account will offer you the best rates. Loyalty doesn’t always translate into favors.
- Refinancing your home to clear an unsecured loan like a credit card debt is a bad idea. Converting credit card debt that may cost 16% in interest to a loan that charges less than 3.96% is very enticing. Unfortunately, if you’re always racking up credit card debt, it will make the problem worse.
- Don’t pursue refinancing to bow to pressure from debt collectors. It will rob you of the opportunity to weigh your options and probably plunge you into financial difficulty.
- If a deal is too good to be true, it probably is. Avoid anyone who is promising to sell your home and buy it back later to save you from foreclosure.
Thousands, if not millions of people have bitten more than they can chew with refinancing just because they didn’t understand how it works. If you’re seriously considering refinancing, it always pays to have as much knowledge about it as you can.
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