If you’re unhappy with your current mortgage rate, or you want to access some of the equity in your home, you may be wondering if refinancing your home is a good idea. With a refinance, you can lower your interest rate and monthly payments, change your term, or take cash out of the property to use.
One reason to refinance your home is to lower your interest rate. The thinking behind this idea is that a lower interest rate means a lower monthly payment and therefore you’ll save money. That may be true, but there are other factors to consider as well to see if it’s better than a home equity loan.
The first is the cost to break your mortgage if you’re in the middle of your term. If interest rates go down before your term is up and you want to pounce on those lower rates, you’ll have to break your mortgage contract with your current lender.
Breaking your mortgage will cost you. Breaking a variable mortgage often costs at least 3 months’ interest, which is more expensive the larger your remaining mortgage amount is. Breaking a fixed mortgage is usually much more expensive – sometimes it could be thousands of dollars!
That’s because of a formula called the Interest Rate Differential (IRD). The IRD is calculated with the difference between the rate that you got for your mortgage originally and the rate that the lender would charge now for a term of similar length. When you refinance your home, you get a mortgage equal to the current amount remaining.
If you break a 5-year fixed mortgage 3 years into your term, the lender would use a 2-year term as the base for their IRD calculation, since 2 years is the amount of time remaining on your term. The average 5-year posted rate of 4.74% in 2015, and a 2-year term today costs 3.29%, so breaking a mortgage with $300,000 remaining could cost around $6,500.
In order for refinancing to be worth it, you must save at least as much over the new term as you spent to break the penalty. Since mortgage rates are actually going up these days, it’s unlikely that refinancing will give you a lower rate. But if you had an unusually high interest rate (perhaps because you got a bad credit mortgage) then refinancing might be worth it.
What if you’re happy with your mortgage rate but need some extra cash for a home renovation? A refinance can help you access your equity and access a lower interest rate at the same time. Since a refinance is replacing your whole mortgage, you don’t have to pay the typically higher interest rates of second mortgages.
However, refinancing for more than your current mortgage amount also has its downsides. Unless you’re using the extra cash on home maintenance, repairs, or renos, you’re securing non-house debt against your house.
What does that mean? If you have credit card debt, the worst thing that can happen is you are sent to collections, your credit score drops, and you get hounded by collection agencies. You may be sued for wage garnishment if your debt is high enough, but that’s an expensive and lengthy process for both you and the collection agency.
If you don’t pay your mortgage, you can lose your house. And since you didn’t spend that money on home improvement, you didn’t increase your equity, so you may get little or no money for selling your home.