Mortgages

Why Is Refinancing Bad

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 6 minute read

It’s hard to imagine, but sometimes the best mortgage rates might actually be the worst thing for your budget. What appears like a steal might backfire if it leads you to make decisions that waste money rather than save it.

When saving up for a large purchase, the option to refinancing your mortgage may look quite appealing. When interest rates are low, homeowners may be tempted to make significant purchases like a car, boat, RV, furnishings, or an extravagant trip, all of which might cause their mortgage payments to rise.

The issue with making such purchases is that their value rapidly declines, increasing your debt while providing no gain in your assets. When mortgage rates are low, taking out cash through a cash-out refinance might actually hurt your net worth in the long run.

You may still make mistakes while refinancing, even if you don’t take any money out. It’s not uncommon for homeowners who often refinance to extend the life of their mortgages beyond the standard 30 years and rack up thousands of dollars in extra interest payments. They are putting their families in jeopardy if they lose their jobs or become ill and are unable to keep up with their mortgage payments.

For your long-term financial health, refinancing may be a wise and even advantageous choice. Unfortunately, there are a number of situations when this is not the case.

Refinancing for the Incorrect Causes

  1. Refinance with Cash Out

Homeowners can “cash out” their equity by taking out a loan on their property’s increased value since their last mortgage refinancing.

Cash-Out Refinance for New Purchases

Assume a couple spent $150,000 on a property five years ago and financed $112,500 of that price at 6% over 30 years. There is a $104,686 mortgage on a home that is currently worth $160,000 to the current owners.

The couple finds out they can get a 4% rate on a new refinancing. Their new maximum mortgage amount is $120,000, an increase of $15,314. With such a low interest rate and a strong desire to upgrade their living quarters with new furnishings and a flat-screen TV, they decide to go for it and extend their repayment period to 30 years.

The couple is obtaining a loan against the equity they have built up in their house. Now, over the next 30 years, they must make interest payments on this loan.

Serial Refinancing With Additional Funds

It’s been three years, and the same pair now has both risen up the ranks. The principal on the mortgage has been decreased to $113,398.47 thanks to the borrower’s punctual payment of the required principal and interest as required under the loan’s terms. Their home’s value has climbed to $165,000, and because to their improved income, they can now afford a $123,750 mortgage.

They considered upgrading to a larger home, but ultimately decided to stay there, justifying their decision as a cost-cutting measure. They take advantage of the still-low interest rates to refinance their mortgage, adding funds, and extending the repayment term to 30 years so that they may take a trip to Europe.

The couple probably won’t be able to afford to pay off their mortgage any time soon. They are now eight years into a thirty-year mortgage, and rather than taking advantage of historically low interest rates, they have continued to sink further into debt. They need both of their wages to make the mortgage payments since the value of their home is not increasing as rapidly as their debt. It’s possible that they won’t generate enough money from the sale to cover the remaining mortgage balance.

They may struggle to pay for necessities like childcare and a mortgage if they start a family, making it impossible for one parent to stay at home. In addition, even though they are lowering the interest rate, they will pay more in total interest if they keep expanding and extending the loan.

  1. Refinance for a 30-Year Term

When refinancing, not all homeowners are looking to get cash out. When homeowners try to refinance their mortgages in the hopes of lowering their interest rate and monthly payment, they may wind up paying more in the long run since they extended their loan term by another 30 years.

A lower mortgage rate may not be the best option.

Five years into a 30-year mortgage term at 4%, a married couple will have paid $74,888 in interest on a principal amount of $104,686. The interest they pay drops to $60,736.83 if they refinance into the 25 years remaining on the original mortgage. By switching to a 25-year term instead of a 30-year term, they save $14,124 in interest and have a lower monthly payment.

The Right Reasons for Refinancing

Although it is prudent to seek out the lowest possible mortgage rate, doing so might occasionally tempt borrowers to take on unnecessary debt. The cycle of constant refinancing may be quite dangerous, as it can lead to a larger mortgage, more interest payments, and a much later date of mortgage freedom.

The following should be taken into account before signing any paperwork related to a mortgage increase or extension:

  • Justification for re-financing
  • To what end will the proposed additional cash be put into the mortgage? In what way does it affect your financial well-being, if at all?
  • Exactly how will this affect your plans for the future?
  • Just how many more years will be tacked onto the mortgage because of this?
  • Does your mortgage carry a prepayment penalty? If that’s the case, how much would it cost to refinance?
  • What are the total fees associated with the refinancing closure, such as application, setup, appraisal, and legal?
  • How long before you make back the money you put into the mortgage refinancing?
  • What is the minimum amount of time you plan to spend at home?
  • Check both your current and new mortgages’ amortization schedules. Mortgage refinancing charges should be added to the new loan’s interest rate to determine the net cost to you. How much more costly is it?

When trying to better one’s financial status, knowledge of the when, why, and how of a house refinance is essential.

  1. Arguments in Favor of a Cash-Out Refinance

If you can refinance with more money and reduce your total borrowing expenses without increasing your amortization time back to the original 15 or 30 years, then you may want to consider doing so. Some homeowners invest the money into home improvements that raise the property’s worth, while others use it to further their education, advance in their careers, and boost their income.

Some homeowners consolidate their high-interest credit card debt with a new, cheaper mortgage loan payment through the refinancing process in order to improve their financial standing and alleviate financial stress. In the event of nonpayment, however, your home might be repossessed because the loan is now secured by your property.

  1. The Mortgage Term and Refinance

One typical motivation to refinance is to lower monthly payments by obtaining a lower interest rate, even after factoring in the fees associated with doing so. Whether or not you’re taking cash out of the home throughout the refinancing process, it’s in your best interest to maintain the mortgage term at the same length as the original loan.

The savings from refinancing into a lower interest rate may be nullified or even exceeded if the loan’s amortization duration or the time it takes to pay off the loan is extended beyond what was originally anticipated.

Bottom Line

Although refinancing can help families save money on interest over time, doing it too frequently without taking into account the whole cost can be a costly error. It’s risky for homeowners to engage in practices like cashing out refinances for consumer purchases, reverting to a 30-year amortization, and incurring substantial mortgage pre-pay penalties to refinancing.

Refinancing your house to pay for frivolous items like new electronics is a bad idea that might put your financial stability at risk. Instead, set short-term financial objectives that will help you save up the money you need.

Refinancing a mortgage with prepayment penalties can add thousands to the total cost of the loan, so it’s best to avoid them if possible. Don’t pursue a refinancing unless you can prove it will get you closer to your long-term financial objectives in any meaningful way.

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