If you’ve been watching interest rates go down or you’ve improved your credit, refinancing your home mortgage could be a great financial move. Or not.
With all the chatter about refinancing, how do you know if it’s a good idea for you?
What is Refinancing?
Refinancing your mortgage means you replace your existing home loan with a new one.
Something many people initially forget is that the process of refinancing isn’t free. (Wouldn’t that be nice?) There are appraisal fees, title search fees, and other costs that you need to ask the lender about.
Is your banker trying to talk you into refinancing with no closing costs? The fees are rolled into the cost of the loan, likely with a higher interest rate. That doesn’t mean the loan isn’t worth considering, but be aware you are still paying the fees one way or another.
Reasons to Refinance Your Mortgage
Even with the costs associated with refinancing your mortgage, it can still be a good idea if the timing and rates are in your favor.
Let’s look at why you might want to consider refinancing.
Refinance Your Mortgage to Save Money
The best reason to refinance is to save money. How would you save money by refinancing? There are a couple of ways it could happen.
Save Money by Dropping PMI
When you refinance, your home will be reappraised. If the appraisal shows that the new conventional mortgage is less than 80% of your home’s value, then you won’t need to carry PMI (private mortgage insurance) any longer.
In reality, this is more of an “icing on the cake” situation. You likely won’t want to refinance only to drop PMI, but it’s a nice bonus if you are also refinancing to take advantage of better interest rates.
Save money on interest payments
The top reason to refinance your mortgage is that you can save a lot of money with lower interest rates. As a rule of thumb, if the difference in interest payments is at least 1%, then the lower rate may be enough to justify the costs.
This change can happen when interest rates drop. Also, if your credit has improved, you may qualify for a lower interest rate than you did with the original loan.
Let’s say 3 years ago you took out a $200,000 30-yr mortgage with an interest rate of 4.75% and you now qualify to refinance at 3.75%. If you stick with that mortgage, you’ll end up paying over $175,000 in interest.
By refinancing to a new 30-year mortgage you can save over $20,000 in interest and possibly recoup the cost of refinancing in 1-3 years. You can save even more on interest payments by refinancing to a 15-year loan.
How the numbers play out completely depend on your situation. It’s worthwhile to check out a refinancing calculator to see how much you could potentially save. The results should also indicate how long it would take to recoup the costs involved in refinancing.
If you speak to a lender, they can let you know the approximate fees you can expect and how much you will need at closing.
Refinance to Lower Your Payments
Another reason to refinance your mortgage is to lower your monthly payments. Why would you do this rather than save on interest payments?
Let’s say you and your partner were DINKs (double income no kids) 3 years ago when you locked in a 15-year mortgage. But now, you have a child and daycare costs are making things really tight with your budget. By refinancing to a 30-year mortgage, you could significantly lower your monthly payments. The trade-off is that you’ll pay more interest over the life of the loan and it will take longer to pay off.
That is a situation where you’ll want to think about how long you plan on staying in the home and whether the longer loan and paying more interest is worth having a lower payment.
Shorten the Term of Mortgage by Refinancing
Another reason you may choose to refinance is to have a shorter term on the mortgage. This is nice if you want to eliminate your mortgage before retiring. If you are 40, taking out a 30-year loan means house payments until you are 70. If you can refinance to a 15-year loan, you’ll be clear of the mortgage when you are 55.
Refinance Your Mortgage to Consolidate Debt
This is an interesting one. I hear of more and more people choosing to consolidate their debt by refinancing their home. When you do this, you get a larger mortgage than needed so you have the cash to pay off your high-interest debts. Essentially, you’ve moved the high-interest debt to lower interest mortgage debt.
If you don’t let the debt creep back up and have no issue with the mortgage payments, this could be a viable option.
However, if you go back into debt, which most people with a lot of high-interest debt do, you really haven’t solved the problem and will end up losing more money. Also, if you have trouble making those new mortgage payments, you risk losing your home.
Tap Equity by Refinancing
If you are considering refinancing to get cash out, you may find this type of refinancing referred to as a cash-out refinance. Note that interest rates on this type of loan may be higher than other types of mortgage loans.
Why would you do this?
Some parents may think that using the equity in the house to pay for college or a new car is a great idea. However, you really need to look at the numbers. It may turn out that the costs associated with the new loan and the extra time it takes to pay off the loan don’t pencil out in your favor.
Is your original mortgage an ARM (adjustable-rate mortgage)? If it looks like you may still be in the home when the initial term is up, you can reduce the risk of higher interest rates (and thus larger payments) by refinancing your mortgage.
Refinance to buy out ex-spouse
If you own your home jointly with someone and have since called it quits on the relationship (divorce, going your separate ways), then you may want to refinance to remove the ex’s name from the mortgage.
When you do this, you often take on a larger mortgage to buy the other person out. This may end up costing you more rather than saving money.
Should You Refinance?
Whether refinancing your mortgage is worth it depends on your situation and how the numbers play out.
It’s possible that despite wanting to get rid of your mortgage sooner than later, the math indicates it would be better to not refinance.
In this case, you can make extra principal payments on your mortgage. By doing this, you’ll shorten the amount of time it takes to pay off the loan and pay less interest.