When market interest rates fall, refinancing is all the rage. It may seem like everyone you know has refinanced and you feel like you're missing out if you don't join them. However, just because some people are saving money with a lower interest rate or cashing out some of the equity they've built up doesn't mean it's right for you.
A major consideration in whether refinancing is right for you is whether you can afford the closing costs. Though you're often able to simply add those closing costs to your existing debt, that will increase the interest on your refinance and impact how long it will take before the interest rate savings outweighs the additional amount added to the loan balance. You can quickly estimate your break even point by dividing your closing costs by your monthly payments savings. For example, if you pay $5,000 in closing costs to save $100 a month on your monthly payments, it will take 50 months -- and more than four years -- until you recoup the closing costs. If you sell the home before then, you're losing money on the refinance.
Just because the market rates have fallen doesn't mean you automatically get a lower interest rate. Lenders look at your individual situation when assigning interest rates on refinances, including your credit score and debt-to-income ratios. If your credit score has taken a few knocks since you took out your original mortgage, or you've taken a lower paying job, you might be offered a higher interest rate on the refinance than you're currently paying.
Dangers of Cashing Out
If you've built up equity in your home, you might be tempted to do a cash-out refinance to take out some of the equity and use the money for other purposes. While it's not always a bad idea, it does come with risk. First, you're pledging your home as collateral, so if you're merely funding a lavish lifestyle consider cutting back on your expenses rather than risking having your home foreclosed on. Second, even if you're investing the money, it won't always pay off. For example, the stock market could drop or the home improvements might not increase the value enough to offset the costs.
Mortgage Prepayment Penalties
Your current mortgage terms might include a prepayment penalty that could eat up all of the savings a refinance could bring. Some mortgages include penalties that apply if you pay off the mortgage too soon, which includes refinancing because you're taking out a new mortgage to pay off the old. If you're refinancing with the same lender, the U.S. Federal Reserve Board suggests asking if any prepayment penalties can be waived. If not, make sure you include the prepayment penalties with the closing costs when you're running the numbers for how long it will take you to recover your costs.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."