When You Should Refinance Your Mortgage—and When You Shouldn’t

Many people might assume that refinancing is always the right thing to do, especially when interest rates are as low as they are. For most homeowners, that might be true. But it isn’t true for all.

When you should refinance

It’s usually pretty easy to know when you should refinance your mortgage. There are usually tangible financial benefits, such as the following…

When the payments will drop. Lowering your monthly housing payment is probably the biggest single reason for anyone to refinance. You’re lowering your expense and improving your cash flow and that’s the key to so many other positive outcomes. Just be sure that the lower payment is the result of a lower rate and not from extending the loan term.

When you can reduce the loan term. As long as you can afford the higher monthly payment, it’s generally worth it when you can shorten your loan term. The reduction of a loan from 25 years to 15 will knock 10 years of payments off your loan, even if you will be paying more in the short run.

When the interest rate will be significantly lower that what you’re paying now. Lower interest rates don’t just mean lower payments, they also mean that less of your payment is going to interest—which is an expense—and more is going toward principal. With that arrangement, not only are you paying down a debt (the mortgage) but you’re also increasing an asset, the equity in your home.

When you have a chance to move out of an ARM. Yes, adjustable rate mortgages often carry super low rates, and yes, they can adjust downward in a lower rate environment. But they can also go up when rates rise, as much as five or six percentage points above the initial rate of the loan at the start. Since mortgage rates have been dropping pretty steadily over the past few years, many people are unaware of this possibility. If you can refinance out of an ARM and into a fixed rate loan, it’s always a good idea. Never look at your 2.5% ARM rate and compare that to a fixed rate at 3.75%. Instead compare your maximum rate (2.5% plus the lifetime cap of six percentage points, or 8.5%) and make your decision based on that. The comparison looks a lot different when you do.

And when you shouldn’t

No matter how low interest rates are, refinancing is NOT always the best move. Your own personal circumstances are usually more important then the rate. Some of those situations include:

When you only have a few years left on the loan. Refinancing a loan that has 25 years left on it can make a lot of sense, but refinancing one with less than 10 years to go usually doesn’t. You have to pay closing costs any time you refinance a loan, and paying them to refinance a loan with only a few years left isn’t the best use of resources. Use a mortgage amortization calculator to determine if you’d be better off increasing your monthly principal payments instead of refinancing the loan entirely.

When the closing costs add too much principal to your loan. This applies mostly to smaller mortgages, the ones well below $100,000. The last thing you want to do is to add $5,000 in closing costs and escrows to a $50,000 mortgage. Better to apply the money as a prepayment of principal and make the loan go away faster.

For debt consolidation. If the housing meltdown has taught us anything it’s that we shouldn’t be using our homes as a place to secure non-housing debt.

When you have impaired credit. The current mortgage environment is particularly unforgiving to people with bad credit. If you had good credit when you first took your mortgage, you probably won’t be able to refinance anyway.

Low interest rates are only one measure of the benefit of refinancing. Make sure you look at your entire situation when deciding if it’s the right move for you.