Securing a lower mortgage rate may be one of the best reasons to refinance, but it’s not always why a homeowner might replace their existing mortgage with a new loan. Generally speaking, refinancing can save you money in interest payments through the life of your loan, which could make it easier to manage your mortgage payments.
That being said, it costs money to refinance, and homeowners should have a specific goal for their new loan before applying for a refi. Understanding the top reasons to refinance your home mortgage (and some scenarios where it’s not the best idea) can help you decide whether it’s the right move for your situation.
Why do people refinance their homes?
Homeowners refinance their homes partly due to market factors (like lower interest rates) that make it enticing for them to take out a new home loan. Other homeowners might refinance because they wish to tap equity, ditch private mortgage insurance, shorten their loan term, or move from one loan program to another.
Even if refinancing could help homeowners lower their interest rates, it does come at a cost. For one, you’ll need to pay refinance closing costs. Even if you see lenders advertising “no-closing-cost refinance,” you’ll still have to pay for things like an appraisal fee, taxes, and title insurance to refinance to a new loan. Those costs will either be rolled into your new loan or you’ll be charged a higher interest rate in exchange for the lender covering the fees upfront.
6 reasons to refinance your home
Here are six of the most common reasons to refinance your mortgage.
Lowering your interest rate and monthly payments
For homeowners who have high interest rates, a rate-and-term refinance is a great way to lower the amount you will pay in interest over the term of your loan. For instance, if you can save at least 1% on your current mortgage rate, you could potentially save tens of thousands of dollars in interest throughout the lifetime of your loan.
Reducing your interest rate may also help you lower your monthly payments. Let’s say you refinance your 30-year mortgage from 4.25% to 2.75% on a $250,000 home to a new 30-year mortgage and you‘ve paid down $50,000 so far. You’ll now make principal and interest payments of $816, compared to $1,229 with the mortgage at the higher rate, saving you $413 each month. Note these estimates do not include refinancing costs, which can run between 3% and 6% of the new loan value. To find out how much you could save, use a refinance calculator.
Eliminating private mortgage insurance (PMI)
If the value of your property has risen since you bought your home, the amount of equity you have may qualify you to get rid of mortgage insurance. In most cases you can eliminate PMI with your existing conventional mortgage once your equity reaches 20% of the home’s value. However, for those who have FHA loans, refinancing is the only way to get rid of mortgage insurance, in most instances.
Switching from an adjustable-rate mortgage to a fixed-rate loan
Homeowners who have an adjustable-rate mortgage (ARM) and are nearing the end of the initial fixed-rate period may find that refinancing to a fixed-rate mortgage will save them from future interest rate hikes. Since the interest on fixed-rate loans remains the same throughout the loan term, refinancing will save you the headache of worrying about how high rates may go up in the future.
Consolidating high-interest debt
Tapping into your home equity is a great way to help pay down high-interest loans, especially since your new loan’s interest rate may be significantly lower. A cash-out refinance allows homeowners to refinance their existing mortgage and withdraw their equity. This can be used to consolidate or pay off high-interest debt, which can improve your long-term financial picture.
Financing home renovations
Tapping into your home equity can also help you add value to your property. A cash-out refinance can help you pay for renovations or repairs that will make your home more attractive to buyers. It could also provide an additional income stream if you decide to renovate your basement into a small apartment or add an accessory dwelling unit (ADU) that could be rented out.
Financing the purchase of a second home or rental property
Purchasing an investment or second home will require a significant amount of money. A cash-out refinance can help you put money toward a down payment. The potential income you receive from your new rental property could be well worth it.
4 reasons not to refinance your home
Determining whether it is a bad idea to refinance your home will depend on the reason you’re doing so. Here are four reasons refinancing may be bad for your wallet.
Cashing out to splurge
Just because you can tap into your home equity for almost any reason doesn’t mean you should. Remember, a cash-out finance is a secured loan — you’re using your home as collateral. Getting a cash-out refinance makes sense if you’re using it for reasons that improve your financial situation, such as home improvements or debt consolidation.
However, refinancing isn’t a great idea when you will receive no tangible financial benefit. For example, if you need to purchase a car or pay for a vacation, you’ll be better off using other means to finance these purchases that don’t put your home at risk.
Extending your loan term
Refinancing your mortgage at a lower rate may sound like a good idea, but your new loan could cost you more in the long run if you extend your term. Even if your monthly payments are lower, you may pay more on your loan overall. Use a refinance calculator to make sure you are saving enough in interest to make this option worth it.
Refinancing when the benefit isn’t enough
Refinancing your mortgage comes at a cost in the form of closing expenses and potential prepayment penalties on your current mortgage. For refinancing to be worth it, you’ll need to consider the break-even point, which is the amount of time required to recoup these costs. If you plan on moving before you reach the breakeven point, then the costs will most likely outweigh the benefits of a refinance.
Paying off your mortgage faster without a backup plan
Tying up cash in your home, such as with a shorter-term mortgage, may put your other financial goals at risk. The wealth you build into your home is illiquid, meaning you can’t access it quickly. That might result in having less money to pay down high-interest debt, save for retirement, or your children’s college tuition. Paying more each month to shorten your mortgage term will get you out of debt faster, but also ensures you have enough room in your monthly budget to cover other bills and unexpected expenses.
Should you refinance your home?
While it may seem like now is a good time to refinance, it’s crucial to think through why you want to refinance your home in the first place. Reasons such as consolidating high-interest debts, renovating to increase your property value all make good financial sense. But still consider your breakeven point to ensure you will recoup the costs of refinancing.
To learn more about the costs and benefits of refinancing, talk to a local Finance of America Mortgage Advisor today.