3 Times a Refinance Is the Wrong Move

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It seems that everyone — your neighbor, brother-in-law, boss — has a lower interest rate on their mortgage loan than you do. And that's probably not surprising, given that mortgage rates have fallen to historic lows, with rates in the mid to high 3% range for 30-year, fixed-rate loans.

That means it's time for you to refinance, right? Not necessarily.

A refinance doesn't always make sense, even if it will reduce your interest rate by more than a point. Several factors play a role in whether a refinance is the right choice: the cost of refinancing in your area, your current interest rate, the amount of time you plan to spend in your home, and how much of your existing mortgage you've already paid off.

Too many homeowners, though, only pay attention to how much their rate might drop. Peter Grabel, managing director with Luxury Mortgage Corp. in Stamford, Connecticut, says that this is the wrong approach.

"Deciding whether to go ahead with a refinance requires not just an analysis of how much you might save each month, but also a look at your entire life," Grabel said. "You need to look at your age, your income, your future plans. You need to take on a real study of your life and your goals before deciding whether refinancing makes sense."

Here are three times when a refinance might not be the smart choice.

1. Your Rate Won't Drop Enough to Recover Refi Costs

Refinances aren't free. The Federal Reserve Board estimates that a refinance can cost 3% to 6% of your loan's outstanding balance in closing costs. If your rate doesn't drop by enough, you might not save enough money each month to recover these closing costs for four years or more.

Consider this example: You are paying off a $200,000 30-year, fixed-rate mortgage at an interest rate of 4.5%. Your monthly payment at this rate will be about $1,013, not including whatever you pay for insurance and property taxes.

You decide to refinance. When you approach a lender, you have a remaining balance on your loan of $190,000. You qualify for an interest rate of 4% for your new 30-year, fixed-rate mortgage. At that rate, your monthly payment will fall to about $907, again not including insurance and taxes. You'll be saving about $106 a month, or about $1,275 a year.

But say your refinance costs 3% of your outstanding loan balance of $190,000. That comes out to $5,700 in closing costs. At $1,275 in savings a year, it will take you nearly four-and-a-half years to pay back the costs of the transaction.

And remember, that's at the low end of the Federal Reserve Board's estimate when it comes to refinancing costs. Grabel said that homeowners pay different refinancing costs in different parts of the country. So you might pay more to close your refinance, which would mean an even longer payback time.

If your payback time is too long? A refinance might not make sense. Especially if...

2. You Plan to Move Soon

Refinancing makes more sense for owners who plan to live in their residences for at least five years. These owners plan to stay put long enough to enjoy more months of savings after they've recovered their closing costs.

Grabel recently counseled a couple to skip a refinance. Why? The couple was ready to have their second child and expected to move to a larger home in one or two years. Grabel calculated that the break-even point on their refinance would come a year after they closed it. If this couple did move that soon after hitting this point, the costs and the work involved in a refinance — you'll need plenty of paperwork to close one — wouldn't be worth it.

3. You're Too Far Into Your Existing Mortgage

Here's what homeowners sometimes don't consider: In the early days of your mortgage loan, most of your monthly payment goes toward paying off interest and little to actually reducing your principal, the amount of money you originally borrowed.

But as the years pass, you slowly begin paying off more principal than interest each month. That's a good thing.

When you refinance, though, you start over with a new mortgage. This means that most of your monthly payments will again go toward paying off interest instead of paying down your principal balance.

Starting over might not matter much when you've only been paying off your loan for a year or two. But if you're eight, 10, or 15 years into your loan? Starting over means that you'll be paying much more interest over the lifetime of your new loan.

You'll also reach the end of your loan later in life. Say you refinance to a new 30-year, fixed-rate mortgage when you are 35. If you take the full three decades to pay off this new loan, you'll be 65 before you make your last payment.

This is why Grabel recommends that homeowners who have paid off a significant portion of their existing mortgages take out new loans with shorter terms. Instead of taking out a 30-year mortgage, it might make more sense to refinance to a 15-year or 20-year loan. This way, you'll pay off your loan faster and you won't pay as much interest over the life of your loan.

Again, though, the decision requires an in-depth look at your own financial goals.

"Maybe cash flow is an issue," Grabel said. "Then you'd want to refinance to the loan that gives you the lowest monthly payment. That'd usually be a 30-year loan. But if you are more interested in the lifetime costs of your mortgage, then going with a shorter-term loan that doesn't come with as much interest is the way to go."

Have you re-fied lately? What was your break even?