Pam Etuglavu's Financial Advice

Is applying for a mortgage refinance a good idea?

Refinancing a mortgage happens when a loan is paid off and replaced with a new one. Most homeowners refinance in order to get a lower interest rate, shorten their loan term, convert from an ARM to a fixed rate loan, or to consolidate debt. These reasons all have their benefits and drawbacks; refinancing costs between 3-6% of the loan amount and it requires a home appraisal. Because of the risk involved in refinancing, homeowners should determine whether the benefits outweigh the drawbacks for them.

One of the biggest reasons to refinance a mortgage is to lower its interest rate. Experts used to say that a 2% reduction in interest made refinancing a viable option, but today, one percent is considered adequate. Reducing interest saves money and helps the homeowner build equity faster, while decreasing monthly payments. When interest rates fall, homeowners can often refinance for a shorter term.

Another reason people refinance is to switch between an adjustable and a fixed-rate mortgage. While an ARM offers lower initial rates than a fixed-rate loan, periodic increases can lead to too-high rates. Converting to a fixed rate mortgage can offer a lower rate and shields against future rate hikes. If interest rates are falling, switching from a fixed-rate loan to an ARM can be a viable strategy. It can also be a good idea if a homeowner doesn't plan to stay in their home for a long time.

While the above reasons are all good ones, mortgage refinancing can start a homeowner on the road to debt. Homeowners typically tap their home's equity to pay for big purchases such as remodeling or a child's college tuition. Interest paid on a mortgage is tax-deductible, but increasing the length of time a loan is paid on is hardly ever a good idea.

Many homeowners refinance to consolidate debts. However, the problems that caused the debt in the first place are still there, and many will simply rack up credit card bills after the old ones are paid. Fees are paid on the refinance, equity is lost, more interest is paid on the new mortgage and debt begins to pile up again.

Refinancing is a good idea if it lowers the monthly payment, shortens the loan term, or helps you build equity faster. Using it carefully is a good way to rein in debt, but as with any other financial decision, it requires careful consideration.