Refinancing a mortgage is something many people wonder if they should do at some point in their 30-year mortgage payoff. Most borrowers do not go a full 30 years on the same mortgage.
There are a few reasons people consider refinancing. These include lower interest rates available, needing cash to do home improvements or consolidate debt, or wanting to drop private mortgage insurance.
In this blog, we’ll be discussing common mistakes that you might want to avoid when refinancing your mortgage.
Here at District Capital, we’ve helped several clients through the refinancing process, whether it be helping them decide whether or not it makes sense to refinance, or how best to do it. Thus today, I wanted to share some of my thoughts on the most common mistakes that people make.
Pitfall #1: Restarting the clock for another 30 years.
The first mistake that you want to avoid when refinancing your mortgage is restarting the clock on your new mortgage to another 30 years.
This means that if you’re already five years into your mortgage, you don’t want to extend your mortgage and pay over a period of 30 years, when you would have just paid over a remaining period of 25 years.
It may feel enticing to do another 30 years, since it will lower your current monthly payment and may feel like an immediate savings; however, if you restart the clock to a full 30 years, you’ll end up paying significantly more money in interest than you would have had you stuck to the initial 30-year term of the mortgage.
To avoid this, you can request that your lender amortize the newly refinanced mortgage over 25 years rather than 30. Alternatively, you could do the math and figure out how much more monthly you need to pay on the loan to pay it off in 25 years rather than 30, and then set that up to automatically pay each month.
Pitfall #2: Paying too much in closing costs
The second mistake that you want to avoid is paying too much in closing costs. I’ve seen lenders charge as little as $2,800 and even $2,100, and as much as $5,000-$6,000, all over the last several months.
It is important to comparison-shop for lenders the same way you do for other products. While many lenders offer competitive interest rates, not all offer competitive closing costs. Get estimates from at least 2-3 different lenders to determine the best option for you.
Naturally you’ll need to factor in the quality of their customer service and whether they have the ability to customize the loan according to your needs. At District Capital Management, we typically connect our clients to mortgage lenders that we’ve known for years, whom we both (a) know to be reasonably priced and (b) know will take good care of our clients.
Pitfall #3: Refinancing a home you plan to sell
Refinancing isn’t free. As discussed in pitfall #2, there are closing costs associated with refinancing a mortgage. Not only does a homeowner need to look at the interest rates and consider the reason for refinancing, they also need to determine whether it makes sense financially.
Here’s some quick math that you can do to help you decide whether or not it’s worth paying several thousand dollars in closing costs. Let’s say that with the lower rate that you’re being quoted, you would save $200 per month on your mortgage payments. If the lender is charging you $3,000 in closing costs, divide $3,000 by your per-month savings. $3,000 divided by $200 is 15. This means that it’ll take you 15 months to recoup (or break even) on those closing costs. If you’re planning to stay in that property for significantly longer than that, then it’s a good deal.
If you plan to sell in 12 months in the above example, you will lose money by refinancing.
Pitfall #4: Refinancing to a shorter-term mortgage to pay down the home quicker
Many people have the goal of paying off their mortgages more quickly. This is not always a pitfall or a bad decision. It is just one that takes some consideration.
First, refinancing to a shorter-term mortgage would only make sense if the rate is significantly lower than your current mortgage rate. If your current mortgage rate is lower, the same or even slightly higher than the 15-year, it may be better to simply pay down the 30-year mortgage faster with extra principal payments. This would save on interest and/or closing costs.
Second, it is important to consider whether other goals have been met before paying down the mortgage. Could those extra funds be put to better use paying off higher interest debt or investing in the market for retirement or another future goal?
Before assuming a shorter mortgage always means savings, consider the alternatives as well.
Consider all possible pitfalls when refinancing your mortgage.
When refinancing your mortgage consider all possible pitfalls and benefits before moving forward with that process. Speaking to a professional to help you determine the best strategy for your finances both regarding your mortgage and other financial goals could be the best investment you make for yourself.
If you would like assistance in determining the best strategy for your current and future finances, schedule a free discovery call with us to learn how we can help you.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.