Falling interest rates often send homeowners to the bank en masse to refinance their mortgages. However, even if market rates haven't gone down, you might still benefit from refinancing. Plus, it doesn't mean everyone benefits just because rates go down. Before you sign on the dotted line, consider whether refinancing is best for your situation.
The obvious factor that changes in a mortgage refinance is the interest rate, but it's not the only one. Besides locking in a lower rate, you can also change from an adjustable rate to a fixed rate for the certainty of a stable payment over the remainder of your mortgage. Alternatively, if you think rates are going to go down, you can also switch from a fixed rate to an adjustable rate so you don't have to refinance to take advantage of falling rates. Plus, you can also switch the term of your mortgage loan. For example, if you have 18 years left on your mortgage, you could refinance to a 30-year mortgage to decrease your monthly payments (but it would cost you more in interest).
Cashing Out Equity
Refinancing also gives you the option to cash out some of the equity you've built in your home. For example, if the appraised value of your home is $350,000 and you owe $100,000 in credit card debt, you could do a cash-out refinance for $150,000, pay off the debt and use the $50,000 cash for whatever you wanted, such as college tuition, a new car or adding an extra level to your house. However, cash out with care -- the extra money you borrow must be repaid with interest.
Refinancing isn't free -- whether you pay the costs out of your own pocket or you roll them into the refinance, the average cost is between 3 and 6 percent of your refinance amount, according to the Federal Reserve Bank. At the low end, that means a $250,000 refinance costs you $7,500 in fees. Even if you're saving $150 per month with the lower interest rate, that means you need to keep the new mortgage for 50 months -- over four years -- before the monthly savings equals your costs.
Interest Deduction Limitations
Don't worry -- when you refinance your mortgage, you don't lose your current home mortgage interest deduction. However, you could find yourself out of luck when it comes to deducting all of the interest on your cash-out refinance. Under IRS rules, your cash-out is only treated as home acquisition debt if you use the proceeds to improve your home. If you use the money for something else, it counts as home equity debt, which means you can only deduct the interest on the first $100,000 ($50,000 if married filing separately). If you're cashing out a substantial amount, you could find that some of the interest isn't deductible.
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