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The Good, Bad and Ugly of Refinancing Your Home

Refinancing represented 87 percent of all loans in 2012

Federal Housing Finance Agency statistics show that refinancing represented 87% of the home loans originating in 2012. That's up 3% from 2011, and is nearly three times the rates of 2000. Even the White House recommends refinancing as a way of using record-low interest rates to put a silver lining over our generally cloudy economy.

This doesn't mean everybody should run out and refinance their homes. As with any major financial decision, making the best choice requires an understanding of its pros and cons.

Mortgage rates fell

The Good

A smart refinance loan can save interest in the long term and reduce monthly payments in the short term. This can happen several ways.

Getting a Cheaper Loan. Between December 2002 and December 2012, average U.S. mortgage rates fell 2.5 percent for a 30-year fixed loan and 2.6 percent for a 15-year fixed. This is according to data compiled by research group HSH Associates. That equals to a savings of over $100,000 in interest over the life of either loan.

Better Options. The Fair Isaac Corporation, which compiles consumer credit scores, says that your payment history is responsible for 35% of that score. A home loan you get after a few years of successful, timely payments will have more choices, better interest rates and improved terms from the loan you originally qualified for.

Improved Loan Period. In January 2013, a 15-year fixed rate mortgage cost 0.72% less interest than a 30-year loan. Most families increase income and reduce the principal owed on their mortgage as time goes by. These factors make a shorter loan term possible. Reducing the loan period from 30 to 15 years on a $200,000 loan can save more than $80,000 in interest.

mortgage principal versus interestThe Bad

Banks offering to refinance mortgages are in business to make money and charge fees to do so. This creates downsides to this strategy.

Fees. In their annual survey of closing costs for 2012, found that the average cost to close on a $200,000 mortgage was $3,754. The U.S. Federal Reserve notes these can add up to 3% to 5% the total value of the loan. While these fees are customary, they are also largely arbitrary. Shopping between lenders can cut more than $1,000 off the fees for a loan.

Longer Term. Refinancing a home using a mortgage with the same term as the original loan can reduce the monthly payment but increase your overall interest paid by extending the term of the loan. A family that refinances a 30-year loan five years after buying their home has essentially signed on for a 35-year loan. This also resets the proportion of each payment that goes to interest rather than principal, resulting in more interest expense for the home overall, according to the Federal Reserve.

Lost Equity. Refinancing fees typically go into the mortgage principal, raising the overall sum of the loan. This means less equity to access or leverage. Families who refinance to use existing equity should make certain this loss doesn't make their plans impossible.

flowchart of mortgage and refinancing

The Ugly

Families and individuals with a lot of debt can fall into a vicious refinancing cycle. It works like this.

Step one. Get a mortgage.

Step two. Pay on the mortgage for a few years while accumulating credit card and other consumer debt.

Step three. Feel financial pressure from the combined payments on various debt accounts.

Step four. Refinance the home to access equity, then use that equity to pay off the consumer debt, or incur new consumer debt. CNW Research of Bandon, Ore. reports that using home equity to purchase a new car rose by 52 percent between 2011 and 2012 alone.

Step five. Repeat steps two through four indefinitely.

In the best case, this cycle means never actually owning the home that's being refinanced. In the worst case, the home equity isn't quite enough to pay off the growing consumer debt. Ultimately, the family ends up in foreclosure and/or bankruptcy.

Refinancing the right way means understanding how the change will save money, how much the loan will cost, and making the change for the right reasons. A homeowner with any doubts should speak with a disinterested financial adviser to get all the answers she needs.

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