There are only two valid reasons to refinance your mortgage: to lower your interest rate or to lower your monthly payment (preferably both).
The only great reason to refinance is to lower your interest rate. If you pay closing costs, however, you have to make sure that you are going to recoup your costs. You should determine the crossover point: how many months do you need to pay at the new rate before it pays for the closing costs? Then consider how likely you are to have the mortgage that long.
The other reason to refinance is to lower your monthly payment. This isn’t a great idea, especially if you have to pay a higher interest rate. However, if you’re in a difficult financial situation it may make sense to alleviate your short term burden at the expense of costing more in the long run. Consider what you’re doing very carefully.
However, there is another set of circumstances in which banks would love to get you to refinance. This is to refinance to a shorter term at an equal or higher rate, with a larger payment. But that makes no sense at all for you! In my opinion, it should probably be illegal for banks to offer these loans. Banks love to calculate the savings you’ll accrue over the life of the loan by opting with this plan. You see, what they don’t tell you is that you don’t need to refinance to get those savings.
To see those savings, all you have to do is start paying the larger payment now. Then you will get not only the savings they calculate, but you’ll save the closing costs, and you’ll save money for any difference in interest rate. In addition, you have kept your monthly commitment lower, so that if you hit some harder times, or you need a little extra money at Christmas, you can always choose not to make the extra payment. If you had refinanced, you’d be stuck with that larger payment.
The main concept underlying all of this is that you’re always better off with a lower interest rate. A lot of people don’t understand that. Another application of that idea is that if you have multiple loans (say a car loan, a student loan, and credit card debt), you should always put extra money toward the highest interest loan first. It can be tempting to pay off the lowest balance because it will “feel good” when you’re done with it. But in reality you’re slowing down your ultimate repayment time.
Say you have one loan at 6% and one loan at 10%. If you have an extra dollar to pay toward a loan, it should be the 10% loan. It doesn’t matter what the balances are on the loans. As a rough approximation, that dollar will save you six cents a year until the loan is paid off, if you pay it toward the 6% loan. But that same dollar will save you ten cents a year if you pay it toward the 10% loan. The compounding of interest only makes this advice better.
I was prompted to write this post because my mortgage company’s website always makes these kind of nonsensical refinancing offers, and I can only imagine that someone, somewhere falls for them. Don’t let it be you!