Refinancing often doesn't make sense when you're not planning to be in your home for a long time.
There are plenty of good reasons to buy a starter home before moving on to your forever home. If you're on a budget, buying a starter home -- one that may be smaller or less updated than you'd like -- could make it possible to build equity in a property of your own and stop throwing money away on rent. It will also give you a good sense of what it costs to be a homeowner (think maintenance and repairs) before stretching your budget to afford a costlier place.
If you're in a starter home now, you may be tempted to refinance your mortgage to take advantage of today's historically low rates. Refinancing could save you a lot on your monthly mortgage payments. But while refinancing makes sense for people with long-term plans to stay in their homes, it doesn't always make sense with a starter home.
Why refinancing a starter home doesn't always pay
When you refinance a mortgage, you swap your existing loan for a new one -- one that could potentially have a much lower interest rate. And the lower that rate, clearly, the less you'll pay each month.
But there's a major drawback associated with refinancing a mortgage -- you'll pay closing costs on that loan, the same way you paid closing costs when you signed your original mortgage. Those costs include filing fees, origination fees, appraisal fees, and a host of expenses that aren't always negotiable (though they sometimes are).
Closing costs aren't fixed; they vary from lender to lender. Usually, they're 2% to 5% of your mortgage amount, so if you have a $200,000 mortgage, you're looking at anywhere from $4,000 to $10,000 at closing. Of course, it's possible to shop around for a lender with more competitive closing costs, but these are the numbers you generally find.
For refinancing to make sense, you need to stay in your home long enough to recoup your closing costs and still come out ahead via monthly savings on your housing payments. The problem with being in a starter home is that these homes, by nature, don't lend themselves to long-term living arrangements. That's why refinancing when you're in a starter home may not work out in your favor.
Imagine you're looking at $6,000 in closing costs to refinance your mortgage, after which you'll lower your payments by $200 per month. In that case, it will take you 30 months, or two and a half years, to break even, and only once you've done that will your refinance save you money. Let's say you've already been in your starter home for three years, and your goal is to up-size after five years. If you stick to that plan and only stay in your home for two more years, you won't be there long enough to recover your closing costs.
Of course, some people buy starter homes thinking they'll stay for a handful of years, then wind up in those homes for a decade or longer. And some wind up liking their starter homes so much that "starter" becomes "forever." If you're planning to stay where you are for the foreseeable future or for the very long term, then a refinance could work out in your favor. But before you apply, think about what your life plans look like. If you have every intention of selling your starter home in the near term, you run the risk of losing money by refinancing. So before you give in to the lure of low mortgage rates, spend some time thinking about what really makes sense for you.
Our Research Expert
We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.
The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Copyright © 2018 - 2023 The Ascent. All rights reserved.