Refinancing Considerations with Higher Interest Rates in Divorce: The Pros and Cons

Divorce is undoubtedly a challenging process, and when combined with financial decisions like refinancing, it quickly becomes even more complex. Typically, homeowners refinance to secure a lower interest rate and save money, but in some situations, individuals may consider refinancing with a higher interest rate. This may seem counterintuitive, but higher interest rates can sometimes serve specific purposes during a divorce. 

In this article, we explore the potential pros and cons of refinancing with higher interest rates and why consulting a financial professional is important during this uncertain time.

Pros of Refinancing with Higher Interest Rates

While it might initially seem counterintuitive to refinance to a higher interest rate, there are certain conditions where this financial decision might make sense. 

Immediate Cash Flow Relief: If you find yourself struggling with high monthly mortgage or loan payments during a divorce, refinancing to a higher interest rate, even with a larger loan, could provide much-needed monthly payment relief. This can be particularly helpful if you need a lump sum of cash for various divorce-related expenses, such as settling attorney fees or dividing home equity.

A Short-Term Need: If you plan to sell your property or pay off the loan relatively quickly, opting for a higher interest rate in the short term may not significantly impact your overall interest payments. Many individuals refinance at higher rates with the expectation of refinancing again once interest rates decrease, or even before they put their home on the market for sale.

Tax Benefits: With low interest rates, some individuals may not qualify to itemize their taxes. However, higher interest rates could allow you to itemize this expense, potentially reducing the effective impact of the higher interest rate. Consulting a financial professional can help you determine the after-tax or 'effective' interest rate.

Divorce Benefits: Refinancing can protect you in a divorce by separating your finances from your ex-spouse. Holding a joint mortgage after divorce can lead to credit risks and complications in estate planning. Separating finances as much as possible in a divorce is typically recommended for a smoother transition and a healthier co-parenting relationship. In an extreme example, you need to update wills related to your property once your divorce is finalized because joint rights of survivorship will terminate automatically, and transfer to ‘tenancy in common’ in Colorado. If the non-resident spouse remarries while the house is still owned jointly and passes away, the ex spouse and new spouse would co-own the property!

Income Tax Bracket Consideration: Generally, a higher interest rate refinance may benefit individuals in higher tax brackets, where tax deductions are more valuable. Conversely, it may not be advantageous for those in lower tax brackets or those primarily receiving tax-free maintenance and child support.

Cons of Refinancing with Higher Interest Rates

While the cons of refinancing with higher interest rates may seem obvious, there are some specific drawbacks to keep in mind relevant to divorce.

Higher Long-Term Costs: The most significant drawback of refinancing with a higher interest rate is that you'll end up paying more interest over the life of the loan. Even with lower monthly payments, the total interest paid over the loan's duration can be substantially higher.

Qualification Challenges: Higher interest rates can make it difficult for individuals to qualify for a new home loan due to income constraints, debt levels, or loan-to-value issues. Given the complexity of divorce and changing financial circumstances, qualifying for a higher interest rate can be challenging.

Reduced Home Equity: Refinancing with a higher interest rate means building home equity at a slower rate compared to a lower interest rate. This can impact long-term financial stability and your ability to access home equity for other purposes.

Credit Impact: If you struggle to make payments on time due to increased monthly obligations from a higher interest rate, due to the overall impact on your budget, refinancing can indirectly and negatively affect your credit score.

While refinancing with higher interest rates is not typically recommended due to the potential for higher long-term costs and reduced financial benefits, it's important to run the numbers and carefully assess your specific financial situation and goals. This is especially true during a divorce, when asset ownership gets more complex. Consulting a financial professional, such as A.M. Financial, can help you model different scenarios that take variables into account including tax benefits, financial objectives, and budgets, allowing you to make informed decisions about refinancing. Contact us to learn more about how we can assist you during this challenging time.