Should You Refinance Your Mortgage?
Refinancing a loan can be an opportune way to lock in a better interest rate and save money in the long term. If you’re familiar with student loan refinancing, mortgage refinancing works in much the same way. The only real difference is that mortgage refinancing is used for real estate loans, like those you take out to purchase a home.
When you refinance your mortgage, you replace your old mortgage with a new one so you can access new benefits like a lower interest rate. You can usually obtain a mortgage “refi” from a bank, credit union or online lender.
Nonetheless, refinancing your mortgage isn’t always the best idea. It all depends on your motivations for doing so and the circumstances surrounding your refinance, including your financial health and the state of the economy.
Reasons to Refinance
Most financial experts agree that you should only refinance your mortgage if you have an opportunity to access better conditions on the loan, save money or build up equity in your home faster. You may also wish to refinance if you have an opportunity to pay off your loan faster to reduce overall costs.
Nonetheless, choosing to refinance or not is wholly dependent on your circumstances. It may seem like a good idea to refinance a mortgage, but it may not be the best idea for you specifically. Your financial profile, including your credit score, plays a significant role in the conditions of your loan.
Certain factors outside your control also affect this decision. For example, the overall economy, as well as interest rates set by the federal government, will have an impact on your mortgage refinance. You also need to consider all the fees associated with refinancing, like closing fees, appraisal fees and origination fees.
If you’re considering a mortgage refi, here are some reasons to move forward.
Interest rates have fallen significantly
Your interest rate is one factor that is mostly outside of your control. If you took out a fixed-rate mortgage when interest rates were particularly high, you may feel like you missed an opportunity when they fall significantly years later. It may seem like a good idea to take advantage of these lower interest rates by refinancing your mortgage.
In fact, this is generally considered one of the best reasons to refinance your mortgage. If you can obtain a lower interest rate on your loan, you may be able to reduce your monthly payments. More importantly, you can build equity in your home faster because you’ll be paying more toward your principal loan balance and less in interest.
If you have an opportunity to lower your interest rates by more than half, refinancing is usually a good option. However, it may still be a good idea to refinance your loan if you can obtain an interest rate that is just 1% or 2% lower.
Your credit score has greatly improved
Your credit score is the one thing you can control when it comes to interest rates. If you have a good credit score, lenders will view you as less of a risk and will offer you a better interest rate when taking out a loan.
If you obtained a mortgage when your credit score was low, you may have been stuck with a higher interest rate. If your credit score has dramatically improved since then, you could consider refinancing your loan to access a lower interest rate.
Mortgage lenders also look at other financial indicators when considering borrowers. If you’ve reduced your debt, put away more in savings or gained a higher level of income, you may also qualify for better rates.
To switch to a fixed-rate mortgage and remain in your home
Adjustable-rate mortgages (ARMs) tend to be riskier than fixed-rate mortgages because the rate rises and falls with economic factors. Although they start with a low interest rate, that rate won’t last forever.
If you obtained an ARM and wish to switch to a fixed-rate mortgage, you could consider refinancing, especially if you intend to stay in your home for the duration of the loan term. In doing so, you could prevent paying out large sums of money in interest. You could also feel more secure financially knowing that your rate won’t increase.
On the other hand, you may wish to refinance to switch from a fixed-interest mortgage to an ARM. If you don’t intend to stay in your home for much longer, you could take advantage of low interest rates until you’re ready to sell. This may also be an option if interest rates are falling and the fixed interest rate on your first mortgage is particularly high.
Nonetheless, you must keep risk in mind when making this decision. No one can predict what interest rates will be in the future.
To eliminate private mortgage insurance
You may have been required to take out private mortgage insurance (PMI) if you put less than 20% of the value of your home down when obtaining a conventional mortgage. PMI protects the lender in case you default on your loan, but it adds monthly costs on your end.
There are multiple ways to eliminate PMI. For example, you could request your lender to lift PMI once you’ve built up enough equity in your home. If you’re planning to refinance your mortgage, you can also eliminate PMI if your new mortgage is 80% or less of the current value of your home and you pay the remaining cost. With this strategy, you’re essentially purchasing your home again with a new loan, but this time with 20% or more as a down payment.
To pay off your loan faster
If your income increases or you receive a windfall of cash, you may wish to refinance to a shorter loan term so you can pay it off faster. This will likely increase your monthly payments, but you’ll pay substantially less in interest and build equity in your home much faster.
Reasons to Stick with Your Current Mortgage
As with taking out any other type of loan, there are some not-so-great reasons for refinancing your mortgage as well. In the past, homeowners have gotten themselves into serious trouble by refinancing their mortgages or using their home as collateral to obtain financing that wasn’t necessary.
Refinancing should only be used as a tool for saving on costs or lowering interest rates if possible. Here are some reasons not to refinance your mortgage.
To reduce monthly payments with a longer term
It isn’t usually advisable to refinance your mortgage to obtain a longer term for one very good reason: you’ll end up paying out much more in interest. A longer term means your loan will accrue interest for as long as it’s active. That means you’ll be paying a great deal more toward interest and not to the principal on your loan.
For example, if you took out a 15-year loan on your first mortgage, refinancing to a 30-year mortgage will add additional years of interest payments. Similarly, if you’re refinancing a 30-year loan with another 30-year loan and you’ve already made 5 years worth of payments, you’d be paying an additional 5 years in interest.
You should also consider the fees you may have to pay for choosing this option. Closing costs tend to range from 2% to 5% or more of the original loan principal. According to a 2017 survey by Bankrate, the average closing costs for a $200,000 home totaled $2,084 in lender and third-party fees.
Still, sometimes obtaining a longer loan term is your only option. If you’re facing hardship and you’re worried about defaulting on your loan and losing your home, you could refinance to extend your loan and lower your monthly payments.
To switch to a fixed rate when you aren’t planning on staying in your home
ARMs have a notorious reputation, and that reputation isn’t unwarranted. They may come with a low starting interest rate, but the rates on ARMs rise after this period and then adjust based on economic conditions.
For someone who intends to live in their home for the duration of their mortgage term, an ARM may mean paying much more in interest in the long term if interest rates go up — although it may mean paying less, depending on the circumstances.
If you only intend to stay in your home for a short period of time, sticking with your initial ARM may be a good idea. The low starting rate can help you build equity faster, so you’ll be able to keep more of the money when you sell your home.
To access a lot of cash quickly
It’s possible to use a mortgage refi to access a large amount of cash quickly. For example, if you take out a larger loan than the cost of your home, some institutions will give you the difference as a lump sum, which you can use for almost anything you’d like.
Some homeowners justify this action because they plan to use that cash for an important purchase, such as putting a child through college, but this is a particularly risky choice to make. Cash is easy to spend. Even the most disciplined budgeters are guilty of spending money on things they don’t need when they see a lot of figures in their checking account.
College students often run into a very similar problem with their student loans. They take out as much money as they qualify for, pay for their education, and then use the remaining funds for other purchases. In the end, they are stuck with more debt than was necessary.
The key issue with this strategy is that you end up paying interest on all the extra cash you didn’t need to borrow to refinance your mortgage. Even if you invest the extra money, you may still operate at a loss if your investments aren’t as fruitful as the interest on your loan.
To consolidate other debt
If you have high-interest debt like credit card debt, it may seem like a good idea to refinance your mortgage to consolidate it. With a larger loan than the cost of your home, you could use the extra money to pay off that debt. Technically, this would allow you to pay off the debt at a lower interest rate.
There are several problems with this strategy. For one, you’re transferring your previous debts onto your home. If you can’t meet your new loan payments, you could lose your home because of it.
It’s also quite easy to charge up your credit cards again once they have been paid down. You can’t predict if you’ll need your credit card in an emergency in the future, and it’s always tempting to use credit cards to make big purchases. If you rack up the same amount of credit card debt again, you’ll be left with just as much credit card debt and even more debt on top of it because of your new mortgage.
The Final Word
Mortgage refinancing isn’t a good option for every homeowner, but in certain situations it can help you build equity in your home faster and avoid paying out large sums of money in interest. Before refinancing, calculate how much you could end up paying in interest and fees. You may also wish to speak to a financial adviser as well to make sure the decision is right for you.