Why You Should Think Twice Before Refinancing

More homeowners are trading in old loans for new ones, but doing so comes with hidden costs.

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With interest rates at record lows, homeowners eager to lighten their monthly mortgage payments are flocking to banks to refinance. The Mortgage Bankers Association reports that refinance activity, which now makes up 80 percent of all mortgage applications, is at its highest level in three years. The average rate for 30-year fixed-rate mortgages on loans of $417,500 or less is 3.74 percent, which is the lowest rate in the history of the association's survey.

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But refinancing doesn't always help homeowners come out ahead. Closing costs and fees associated with refinancing can add up to thousands of dollars, which might not be justified by the monthly savings, especially if the homeowner isn't planning to keep the loan for much longer. In general, refinancing costs around 1 to 2 percent of the loan's value. (A Web search for "refinance calculator" turns up some useful number-crunching tools to help homeowners figure out if refinancing makes sense for them.)

Another hidden cost of refinancing is the time, paperwork, and headache involved. Homeowners often have to set aside time to allow for an appraiser to visit their home, and then dedicate an hour or more to the closing itself, which involves signing (and trying to understand) dozens of papers. Particularly for those who are self-employed or paid by the hour, those inconveniences come with real costs.

Of course, locking in the current record-low rates can justify all those costs and inconveniences. If homeowners have an adjustable-rate mortgage that will reset to a higher interest rate after the initial introductory one, snagging a lower fixed rate can be an especially good move.

Some banks are also offering so-called "streamlined refinances," which involves refinancing with minimal paperwork and fees. It sounds too good to be true: If you want to lower the interest rate on your mortgage, just call and ask your bank. They'll do it for you on the spot, without charging much in the way of fees, and within a month, you'll be paying a lower mortgage.

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As unbelievable as it sounds, such scenarios are playing out every day. Homeowners, especially those who have paid their mortgage on time for many months, can take advantage of the currently low interest rates just by making a simple phone call.

"On a refinance with a borrower who has always made their payments on time and their circumstances haven't changed—they have the same job, same income, and their credit hasn't moved—you have a lot of lenders who are willing to cut back on the [refinance] process to save time and cost for everyone involved," says Michael Fratantoni, vice president of research and economics for the Mortgage Bankers Association.

The process isn't entirely devoid of fees—lenders will still want to run a credit check, for example—but they can skip or shorten many of the other traditional expenses. Instead of paying for an appraisal, lenders can do an automated valuation based on statistical modeling, says Fratantoni. Since lenders already know the customer has paid on time for years, then they often feel comfortable relaxing some of the other steps, he explains.

For banks' part, they don't want to lose good customers who are seeking lower rates. That's why they're willing to offer streamlined refinancing. "If you're a servicer and rates have dropped, you know your borrowers will be interested in refinancing. Even though there may be work involved for you, you'd rather keep your borrower then let one of your competitors get them," says Fratantoni.

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As for the fees involved, customers can either pay them upfront, or they can opt for a "cost-free" refinance, which just means the fees are folded into future payments through a higher interest rate.

Still, consumers should also be wary of misleading advertisements that promise no-cost refinancing, which often simply bake the costs into the loan itself, so borrowers still pay them. Borrowers also have no obligation to their current lender, so are free to shop around for different rates.