2 Pitfalls of Refinancing You Can't Forget About

Don't make a refinancing mistake you could come to regret.

Refinancing a home mortgage often makes sense if you can reduce the interest rate you're paying on your loan. Since your new mortgage lender will charge less for the privilege of borrowing, you may be able to lower both monthly payments and total payoff costs. This can make paying your home loan easier.

But refinancing isn't right for everyone. In fact, there may be times when you could significantly reduce your mortgage rate by refinancing but still shouldn't move forward. To help you decide what's best for you, make sure you've carefully considered these two refinancing pitfalls before you opt to apply for a brand new home loan.

1. You could extend your mortgage payoff time

One of the biggest potential problems associated with refinancing your home is that you'll usually end up with a longer repayment time than is left on your current loan.

For example, it's common to refinance into a new 30-year mortgage. But if you originally took out a 30-year loan and have been paying on it for a while, refinancing will reset the clock and push back when you'll become debt free. That means you'll get stuck paying interest to your new lender for a longer period of time than you would have been paying financing charges if you'd kept your original mortgage.

In some cases, the impact of these extra years of interest payments can end up offsetting any savings that comes from lowering your interest rate. In fact, you could find yourself paying more for your new mortgage -- even if your rate is quite a bit lower -- if you opt for a much longer payoff period.

By extending your payoff time, you'll also have to wait longer to become debt free and enjoy the benefits of eliminating the biggest chunk of your monthly housing bill. This could make it more likely you carry a mortgage into retirement, especially if you refinance multiple times or do so late in life.

You can avoid this by making sure you don't extend your payoff time much, if at all. If you've been paying your current loan for a while, refinancing to a 15-year or 20-year loan could make much more financial sense, even if it means you can't drop your monthly payment as much.

2. You'll have to cover closing costs

When refinancing your mortgage, you'll also need to consider the upfront costs associated with the process, which could add up to as much as 2% to 5% of the value of your loan.

Closing costs are for things like loan origination fees and appraisals. While some lenders allow you to roll the costs into your loan or pay a higher interest rate to cover them rather than paying a lump sum upfront, ultimately you always end up having to pay these expenses.

Because of high closing costs, refinancing may not make sense if you're going to move soon or if you refinance too often. You need to make sure you compare the closing costs you'll face to the amount you'll save when deciding if refinancing makes sense.

Let's look at an example. If you drop your monthly payment by $65 per month by refinancing but it costs you $4,000 to do it, it would take you almost 62 months -- or just over five years -- to break even. So you'd need to be confident you'd stay in your home at least that long in order for refinancing to be a smart move.

By considering these two pitfalls, you can make the best and most informed choice about whether to refinance or to stick with your current home loan.