You're having money troubles, so you start to think about refinancing your mortgage. Then you realize that you’re not completely sure what the pros and cons of refinancing a home are. In fact, you're not completely sure what refinancing actually means.
It’s okay. Let's start at the beginning.
What is refinancing and how does it work?
When you're in the process of paying off a loan, mortgage or otherwise, you may find that the terms of the loan aren't as helpful to you as they were when you borrowed. Maybe your credit improved and you now qualify for a lower interest rate. Maybe the market itself has changed and interest rates are lower overall.
So you look into refinancing, a process that lets you take out a new loan that pays off your old one. Then, instead of repaying the loan you originally took out, you're paying back the new loan with its different terms.
Why would you do it?
Refinancing still leaves you with the same amount of mortgage principal, but it can save you money in the long run. You might be able to arrange:
- Lower interest rates
- Reduced monthly payments
- A switch from variable to fixed rate or vice versa
You might choose to refinance a 30-year mortgage into another 30-year mortgage, giving you more time to pay. Or you might choose a 15-year term for your refinanced loan, a move that will probably lower your interest rate.
Another option is to borrow more than you currently owe. That way, you can pay off your original loan and take the rest as cash, which you can use to renovate your home, start a business, or pursue another personal goal. This is known as cash-out refinancing.
What are the cons of refinancing a mortgage?
Before you make any major financial decision, you need to look at the negatives as well as the positives. So what are the disadvantages of refinancing? Let's look at five of the biggest downsides.
1. Refinancing is expensive.
Refinancing a mortgage isn't like exchanging one shirt for another if the first one didn't fit. You're taking out another loan, and that means you'll be dealing with fees and closing costs.
According to ValuePenguin, the closing costs on a mortgage refinance are similar to the costs of taking out a new mortgage. That means that if your home is valued around the national median, which is currently $198,000, you'll be paying more than $7,000 in closing costs, a total that includes:
- Mortgage application fee (average cost $235)
- Property appraisal fee (average cost $480)
- Loan origination fee (1 percent of the principal)
- Title search and insurance (average cost $733).
You'll also need to pay a local recording fee, which updates your deed to include your new mortgage, and you may owe a reconveyance fee to your original lender. Your savings might make up for the amount you owe in closing costs, but that could easily change if you have to sell your home before you've broken even.
#2. You'll lose some equity (and maybe more than “some”).
Unless you pay your refinancing expenses in cash, those costs will be incorporated into your new loan. That adds to your balance owed and effectively reduces your equity.
You give up even more of your equity if you choose a cash-out refinance, simply because the cash you receive comes from the equity you've built up. For example, if you owe $150,000 and have $100,000 in equity but refinance for $200,000, you now only have $50,000 in equity. That could get you into trouble if the value of your home drops.
#3. You could get a low appraisal value.
Lenders use appraisals to determine the fair value of your home, and that value is what decides your loan amount as well as your interest rates. An appraiser will visit your home and note its condition and features, then value the property based on recent sales of similar homes in the area.
If you're in a market where home values are down, or where there have been too many short sales or foreclosures, you might find your home low-balled in the appraisal process. That may leave you unable to refinance until you can build up your equity or get a higher appraisal.
#4. Amortization could leave you paying more.
Every mortgage amortizes over time. This means that to keep your payments stable, or as stable as they can be in the case of variable rate mortgages, you pay off more of the principal per payment as your total balance decreases.
Your total interest costs are higher in the first years of your loan repayment, simply because your balance is higher. (Remember, 4 percent of 200,000 is more than 4 percent of 150,000). If you're well into your loan repayment, you may find that the amortization on your new loan will outweigh any savings.
#5. You could see a drop in your credit score.
Refinancing your mortgage can hurt your credit in a number of ways. First, every time you apply for a loan, the lender runs what's called a “hard inquiry” on your credit.
Too many inquiries
Multiple inquiries for a similar loan type within a short period of time, usually less than six weeks, will typically appear as a single inquiry and won't cause your score to drop significantly. However, it if takes you a few months to shop around, you could have multiple new inquiries on your report. That can lead to higher interest rates when you do pick a loan.
New credit vs. old credit
The age of your debts counts for 15 percent of your FICO credit score. If you pay off an older mortgage and switch it for a new one, your average account age decreases, possibly to the detriment of your score.
Your credit utilization
Whenever you tap your home equity in a cash-out refinance, you're taking on more debt. More specifically, you're increasing the percentage of your available credit that you're using. The closer your debt gets to your available credit total, the more your score will drop.
Tap Your Home Equity Without Refinancing
There are safer ways to get your hands on your equity. The traditional way is to sell your home and move, but that can feel like adding insult to injury when you're having financial difficulties.
EasyKnock understands how painful it can be to feel like you have to leave the home you love. That's why they've created Sell and Stay, a program that lets you sell your home but remain in place as a tenant. You get access to your equity and you get to continue living in the home you love.
You can continue renting through Sell and Stay until you're ready to buy your home back or move, whichever suits you best. The finances of both options are arranged in advance, so you'll find no surprises.
If you're concerned about the negative consequences of refinancing, consider a completely different option. Check out Sell and Stay today and learn about a safe and flexible alternative to refinancing.