When is Refinancing a Bad Idea?

With interest rates changing over time, refinancing your mortgage may be something you consider at some point.

By refinancing when interest rates are lower than your current rate, you can reduce your monthly payments, save on the total amount of interest due and may even be able to pay off your loan sooner. It can be a great option for homeowners.

But refinancing isn’t free, and it’s not always going to save you money in the long run. When you refinance, you change your mortgage by replacing your current mortgage with a new one that has its own rate and length. While there are certainly times when refinancing is the right choice, there are also times when it is the wrong choice. Let’s explore some reasons not to refinance to help you decide.

It Will End Up Costing You More

Don’t just look at the interest rate and assume the new loan will save you money. After factoring in the oft-forgotten closing costs, you need to examine how refinancing will affect your finances in the short term and in the long run. For example, in the short term, refinancing a 30 year mortgage into a 15 year mortgage could raise your monthly payment to an amount you can’t manage and leave you struggling every month. Conversely, by refinancing a 30 year mortgage into another 30 year mortgage, you are extending the duration of the loan and therefore increasing the amount of time you pay interest, which can end up costing more. Run the numbers. Use a refinance calculator if you need. If the refinance would cost more than your current loan or leave you unable to afford your monthly payment, you may want to reconsider.

Breaking Even Will Take too Long and/or You plan on moving soon

Remember, refinancing brings fees and closing costs that you have to pay. In order to save money in the long run, you will first need to break even on the money you spent on closing costs. The breaking even period is the amount of time it takes you to recoup those costs, break even and start actually seeing the savings. If it takes too long to recoup that money, it may not be worth refinancing. And how long you stay in the home has a big effect on this. To give you an idea of your breaking even period, you can divide your closing costs by your monthly savings. You can estimate your monthly savings based on your new interest rate, or you can reach out to the lender for an estimate. For example, if your closing costs are $3,500 and your estimated monthly savings come to $40, then 3,500 ÷ 40 = 87.5. That means you will break even in 87 ½ months or 7.29 years, and you will not see savings a minute sooner. If you plan on moving before that time, then refinancing would not make sense, because you will recoup the money in time to see the savings.

You Can’t Afford the Closing Costs/Fees

Closing costs, which can include attorney fees, loan origination fees, servicing fees, underwriting fees and more, can be anywhere from 2-6% of your total loan amount. So with a loan of $250,000, for example, you could spend $15,000 on closing costs alone. That’s considerable. To cover these costs, you can pay them in cash upfront, or you can pay a higher interest rate or roll them into the cost of the loan. This is also called a no-cost refinance. But, of course, nothing is actually free, and you do have a cost with a no-cost refinance–you have to pay interest on those closing costs for the duration of the loan. Do the math. Is it worth refinancing when you factor in the closing costs? Is it worth refinancing when you also have to pay interest on the closing costs for the next 30 years?

Cash-Out Refinance

With a cash-out refinance, you use the equity in your home as collateral in return for cash. This can be a good option for smart homeowners who plan to use the money for reasons such as a renovation to increase their home’s value. But it can also be very risky, considering how easy it is to spend money quickly. And it may not be advisable if you are someone who is not careful with money, has a spending problem or is not going to spend the money wisely in ways that will benefit you long-term, such as paying for a party or a trip.

Changing the Type of Loan

During a refinance, you may choose to switch the kind of loan you have (fixed-rate vs. adjustable-rate), but that may not be the best choice, even if the new rate is lower. If you currently have a low fixed-rate mortgage, the new rate would need to be considerably lower for you to see savings after you factor in closing costs. So you may choose to get an adjustable-rate mortgage since they generally have the lowest rates. Fixed-rate mortgages keep the same interest rate throughout your loan. Adjustable-rate mortgages tend to have lower interest rates, but they change and reset every so often, which can be riskier, because you don't know what the rate will be in the future. The risk is if you switch when rates are low, chances are they won’t go any lower and will ultimately go up, meaning you’ll have to pay more interest. So as enticing as it may be to refinance with that lower rate, this option could end up costing you more once the rate resets and increases.

Consolidating Your Debt

Consolidating debt means combining multiple different debts (such as credit card debt, a mortgage and student loans) into one single loan with one monthly payment. It can be a good option in many scenarios. And it may seem like a no-brainer to pay off some of your higher-interest debts with a low-interest mortgage, but beware. Debt consolidation can be incredibly dangerous, because you are using your home as collateral for those other loans. So if you fail to make your payments, you can lose your home. Whereas, if you have your debts separate and fail to make credit card payments, you will hurt your credit score and face creditors, but you will not lose your home in a foreclosure.

How often should you refinance your home?

There is no legal limit on how many times and how often you can refinance your mortgage. But your lender may have its own policies regarding this, such as charging you a financial penalty for refinancing too soon after getting your original mortgage (usually within 3-5 years). You also may not be able to refinance again depending on your credit score and equity in the home. Your lender may require you to have a certain amount of equity and credit score to grant you a new loan. So if your credit score dropped since your last loan or you don’t meet their equity minimum, you may not qualify.

But regardless of how often you CAN refinance, you won’t want to do it often. Every time you apply for a loan (credit card, car loan, refinance, etc..), your credit briefly decreases. However, many credit applications can lower your credit score long-term and negatively impact your financial situation. Not to mention, with each refinance, you pay closing costs that are approximately 2-6% of the loan. And when considering how long it will take to recoup that money and break even, refinancing is often not a wise decision. Plus, if you bought your home or refinanced during the pandemic when interest rates were at historic lows, what are the chances you will find a lower interest rate in the future?

The Bottom Line

Refinancing can be helpful for homeowners looking to save money on their loan. But it can also go wrong. Only you can determine if refinancing is the right option for you and your unique situation. But if you do refinance, make sure that: you can afford the closing costs; it’s not costing you more in the long run or making your monthly payments unaffordable; the interest rate is significantly lower; and you will live in the home long enough to see the savings.