Record low interest rates creates yet another refinance boom. Banks and brokers benefit big time but what about you and me? Just because you lower your interest rate, does not mean you are saving money. Refinancing could have a positive appearance and still hurt you.
There are times refinancing can save you thousands of dollars and get you closer to your goals, but is it always a good idea?
1. Extended Break-Even Periods Negate Short-Term Savings
When I analyze a refinance, I start with the break even point. This is the point where you recoup the cost of doing the loan with the monthly savings. To calculate this, you take the cost of the refinance, which will include all your lender fees, appraisal fees, and closing costs, and divide that by the monthly savings. This will give you the number of months it will take to recoup the costs.
I recently refinanced a couple of properties with a break-even of almost four years. That is normally way longer than I would want to see but I never plan to sell these homes so I have a high level of confidence I will still own them after four years. I did not believe I would get an opportunity to lock in the rates that I did, so I went for it. Although it will be four years to break even, I know I will save a ton of money by doing this refinance.
2. The Closing Costs Can Be Steep
I was shocked at the costs of doing the loan with my last refinance. These were smaller loans so with fixed costs, like appraisals and closing fees, the total costs to close as a percentage to the loan amount was high. Granted, you can most likely roll the costs into the loan but even that comes at a cost. Rolling closing costs into a loan means you will be paying interest on those fees for the next 30 years.
Be sure to review your cost estimate from the lender and question the fees. Do this before committing to the loan and before ordering the appraisal. There are also often ways to reduce your interest rate by increasing your closing costs. These are called “buy downs”. Go through your buy down options with your lender and see what the breakeven point is for each option. Oftentimes it makes sense to stick with a slightly higher rate to keep closing costs down.
3. You’ll Be Stuck Paying Off the Interest First Again
Amortization schedules are an amazing tool for keeping payments consistent through the life of the loan, but they create a devastating downside. Have you ever looked at your mortgage statement to see how much of your payment is applied to principal? Amortization schedules, although needed, hurt borrowers in the early years of the loan. The majority of your payment is applied to interest and very little goes to actually paying off the loan. As you work your way through the amortization schedule, you will notice that more and more of your payment is applied to paying off the loan. With a 30-year loan you need to wait more than 15 years before even half of your payment is applied to the loan. A major downside to consider when refinancing is that you will be restarting your amortization schedule and will be starting over. That will mean, most likely, more of each payment you make is once again going to interest. Sophisticated borrowers will consider this when they are making refinance decisions.
4. Saving Money in the Short-Term Could Cost You in the Long-Term
This is true for a few reasons. First, as we have discussed, you will most likely be pushing out your amortization schedule, meaning you will be paying more interest each month but that also means you will be making payments on the loan for a longer period of time as well. Each time you refinance, you are probably pushing your pay off date further and further away.
Another time this could cost you in the long term is if you get an adjustable rate loan. Many of these adjustable rate loans have fixed starting rates. The rate could be fixed for five, seven or even ten years, but after the fixed period expires, the rates can adjust. These adjustable rate loans come with low starting rates, saving you money now, but could cost you big time if rates increase.
5. Poor Credit Can Result In Worse Terms
There are many considerations a lender will go through when deciding on an interest rate. Anything that creates higher risk for the lender, means they will charge a higher rate. A low credit score is just one of these items. If you have a lower score now than you did when you got the loan, there is a decent chance you will not be saving any money by doing a refinance. In these cases you might see your monthly payment go down but that is largely because you are extending the pay off period, not because you are saving money.
6. Consolidating Debt Won’t Automatically Save You Money
Consolidating debt can have huge positive impacts on borrowers, especially with monthly payments and a plan to pay debt off. But it can also hurt you.
Credit card debt is extremely tough to pay off because minimum payment requirements are purposely structured to extend the time it takes to pay the debt off. It also allows you to re-borrow after you reduce the debt. Sometimes moving these debts into a refinance is the only way to move forward – but be careful. By doing this you are extending the debt out 30 years and will have the ability to use your cards again, which puts you in a much worse position and ends up costing you a lot more in the long run.
The topic of debt consolidation is a tricky one. Often it is best to get some help from a professional. Even when the loan appears to benefit you, it might not; or if it appears to hurt you, it might be helping. I remember one deal I worked on when I was a mortgage broker where we consolidated credit card debt and my client’s monthly payment went up. That was not a great scenario for him in the short term but provided a huge benefit in the long term. In this example, we did a loan with no prepayment penalty and no costs. No cost loans are possible with higher interest rates. We wiped out all of his credit card debt, which was significant. The result was an increased credit score of over 100 points! With the new higher credit score he qualified for much better loans so we waited about six months and refinanced him again saving him over a thousand dollars a month. His short-term increase in payment with the debt consolidation loan might have saved him from an eventual bankruptcy. I just hope he stopped using his credit cards.
7. Refinancing a Mortgage Can Take Too Long
If you are considering a refinance to free up cash, be aware of the length of time you need to get to the finish line. Refinance loans often take a back seat to a purchase loan with a deadline and can take longer to close. If you are relying on those funds for your own deadline, like buying more rental property, you run the risk of not having the money available when you need it.
Making The Right Fiscal Decision
There are many different reasons you might be considering a refinance. Refinancing a home or rental property can have huge benefits. It allows you some flexibility to speed up your payoff timeline, you can reduce monthly payments, or it can free up some much needed cash. There are different types of lenders that can help you with a refinance including your traditional lenders and banks but if you need to free up cash to complete a construction project, you might need to consider hard money. Hard money lenders can be very expensive but can get you the cash you need when you need it. They also get you to the closing table fast. When done correctly, a hard money refinance will get you to the finish line.
It is important to see the downside of refinancing a property in order to make the best fiscal decision. Understanding rates, terms, and amortization schedules are all important to analyzing the deal and making the final decision. This can be a tricky decision to make so don’t do it alone. Contact a lender that you trust to dig into your situation to see if refinancing is right for you.