To be clear there are two kinds of refinancing – cash-out refinance & no cash-out refinance.
It is important to fully understand what is happening when you refinance. Most understand that when you do a cash-out refinance, the cash received is coming from the equity in their home. However, it is important to consider the implications of doing so.
With the cash-out refinance it may feel like the right thing. You might think ‘How could it be wrong? the bank is giving me money and my monthly payment is lower,’ but in reality, you end up paying much more than the money you receive. This is because you’re restarting an entire debt cycle from the beginning, which means a whole lot of interest is paid to the bank. So instead of selling the home and profiting off the equity, that equity is now debt that needs to be paid back with interest on top of it.
This is especially heartbreaking because the equity being pulled out usually had already been earned by paying down the original loan for 5, 10, 15 years. In such a case the borrower ends up paying a considerable amount of interest on principal they already paid a considerable amount of interest on! Essentially the borrower is almost out of the woods of extremely interest-heavy payments and then they turn around and run back in to pay the bank more interest on equity they already paid for.
With all this said it is not always a bad idea to do a cash-out refinance. There are certainly cases that which a cash-out refinance can be a good idea. However, these situations usually have one of two things in common – the money is being used to invest in something that will produce a return that would otherwise not be possible. Or the money is being used to pay off other debts such as medical bills or student loans that have a higher cost and after calculating it is clear that refinancing will allow you to pay less in interest across all your debts.
A no cash-out refinance can often be a good idea and help to save money in the long run if interest rates have gone down since the original loan. The calculation to find out if a no cash-out is a good idea is simple. Look at the principal balance left on the loan. Then look at the amount of interest left that is left on that balance if continue to make payments regularly(you can do this by plugging in your loan information to a free online amortization calculator.) If the total amount of interest that will be paid on a new loan is less than what is left to be paid on the old loan, then it is a good idea! If not keep the old loan in place. It is important to remember that a lower monthly payment does not mean you are saving money!
Like all things financial there is no one size fits all answer to what is best for you. We all have different debts, incomes, responsibilities, and ideas for the future. But the one thing we all do have in common is the importance of avoiding debt and interest payments as often as possible! Because there is no one size fits all answer, the only way to find what is best is to calculate, calculate, calculate and see options that allow you to do what’s best for yourself and your family.
