4 reasons not to refinance

By Liz Pulliam Weston

Mortgage refinancings keep hitting record highs as interest rates dribble to generational lows. That doesn't mean everybody should join the party, however.

"Out of every 10 calls I get, probably three of them really shouldn't refinance," said mortgage broker J.J. Sims, owner of ABC Mortgage in Minneapolis and a member of the National Association of Mortgage Brokers' board of directors. "A lot of people get caught up in the hype of lower interest rates and don't really think it through."

The most obvious case of when refinancing doesn't make sense is when the homeowner won't live in the house long enough for the savings from a refinancing to outweigh the costs of getting a loan. (I'll tell you exactly how to figure that out below.)

Any of the following also can be red flags:

• Have you been paying a long time on the loan you already have? If you're 10 or 20 years into a 30-year mortgage, refinancing to another 30-year loan may only increase your costs in the long run.

• Is your credit worse than the last time you got a mortgage? If you've missed payments, run up big credit-card bills or otherwise stressed your credit, you may not qualify for a low enough rate for refinancing to make sense.

• Have you already stripped all the equity out of your home? To get the best rates, you'll need to keep your borrowing to less than 80% of the value of your home. Refinancing might not make sense if you've already borrowed 90% or more of your home's value in mortgages and home equity loans.

• Do you have a spending problem? Taking out extra cash during a refinancing to pay off credit-card debt is a popular tactic these days -- and a huge potential mistake. You've turned what should be short-term debt into long-term debt, which can cost you more in the long run despite the tax advantages from being able to write off the interest. You've also put your home at greater risk and compromised your financial situation should you ever have to declare bankruptcy.

Cut up the cards

In fact, "people who take out money to pay off credit cards and have no intention of changing their credit-card behavior" are No. 1 on economist Doug Duncan's list of those who shouldn't refinance. These overspenders usually continue racking up big debts and sucking out more of their home's equity, leaving themselves vulnerable to bankruptcy and foreclosure. Duncan, chief economist for the Mortgage Bankers Association of America, believes people with big credit-card debts need to learn to live within their means before they even consider tapping their home equity.

I'd make the caution even stronger: You need to be willing to cut up your credit cards and live on cash, so you don't find yourself underwater in a few years.

To determine whether refinancing makes sense for you, you'll first need to jettison the idea that there's some rule of thumb that can make the decision for you. It used to be, back in the day when everybody got 30-year fixed mortgages and refinancing costs were high, that interest rates had to fall at least two points below your current rate for refinancing to make sense.

Now there are so many different kinds of mortgages -- 20-year fixed, 15-year fixed, adjustable rate and hybrid mortgages that are fixed for three to 10 years before becoming adjustable -- and so much competition driving down costs that rules of thumb don't really work anymore.

Set goals, read up, calculate

Here's how to know if you should refinance:

Define your goals. Do you want to lower your monthly payments? Build equity faster? Get money for a home improvement project or other cause? Each goal will affect the kind of loan and terms you'll face.

"Once the goal is established it is pretty easy to see if (refinancing) makes sense or not," said mortgage broker Allen Bond of Palos Verdes Funding in Palos Verdes Estates, Calif. "Some people are actually going from a 30-year to a 15-year loan and increasing the payment, but saving considerably over the long run. For those that just want (lower monthly payments), that would not make sense."

You may be able to accomplish more than one goal, though. Duncan, for example, recently refinanced from one 15-year loan to another at a lower rate. He not only lowered his payment but got cash out to help pay for a child's college education. (He did have to pay a slightly higher rate than had he simply refinanced what was left of his mortgage balance -- typically taking cash out of a refinance will increase the rate you pay.)

Educate yourself. Read about how the refinancing process works, get a copy of your credit report and score so you know how lenders view you, and start shopping for rates and terms.

Start with your current lender, who has an incentive to try to keep you as a customer. Don't stop there, however.

"There are 7,500 lenders out there," Duncan said. "If you're talking to just one, you're not taking advantage of the competition."

Web sites such as E*Loan can give you a good idea of what the costs are for refinancing to a variety of different loans. You can also call several lenders or use a mortgage broker (preferably one who's been in the business several years and who is affiliated with National Association of Mortgage Brokers) to help you review your options and the associated costs. Working with a good broker can be especially smart if you have troubled credit, since the rates typically quoted on Web sites may not apply to you and you're at greater risk of being a victim of so-called "predatory lenders."

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