A refinance takes place when you acquire a new mortgage to replace your original loan. There are many reasons why homeowners might consider a refinance, such as reducing interest rates, paying a home off more quickly, lowering monthly payments, or changing loan types.
Refinancing your home can be a major money saver...or it could become a grave financial misstep. You’ll need to know the difference in order to make wise decisions about the future of your mortgage loan. Here are four reasons to refinance your home, and when to be careful:
Reason #1: Refinance to lower your interest rate
This is one of the best reasons to refinance your home. By reducing your interest rate, you can save money over the length of the loan. You’ll also build equity more quickly as more of your payment will go to principal rather than interest.
Try using a refinance calculator to get an idea of the effects of a reduced interest rate.
Reason #2: Refinance to pay your loan off sooner
Refinancing at a lower interest rate can shorten a loan term significantly while keeping your payments around the same amount.
For example, you could switch from a 30-year mortgage to a 15-year mortgage while maintaining a similar monthly payment. And since you’ve most likely paid a significant portion of the loan down by the time of refinance, your home could be paid off within a decade. Pretty exciting!
Typically, a 1-2% reduction in interest is enough to make associated fees worthwhile. We’ll address those fees in a moment.
Reason #3: Refinance to change your loan type
Typically, this type of refinance is initiated to convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage. Before you make the swap, it’s important to consider three things:
- The current interest rate environment. It may not be wise to switch from an ARM if interest rates are expected to decrease.
- Your personal situation, such as approaching retirement plans and how long you think you’ll be in your current home. If you’re planning on selling in the foreseeable future, you may be better off continuing to ride the interest-rate roller coaster and avoiding refinance fees.
When you refinance to change your loan type, you may have the option of resetting to a new loan term to lower your payment. For example, you could start over at day one of a 30-year mortgage. Lower payments can free up some cash, but starting over on a three-decade loan commitment certainly has its drawbacks.
Reason #4: Refinance to access equity
Although fairly common, this is one of the riskier reasons to refinance your home. Reasons for this type of refinance include remodeling to add value to the home, reducing your homeownership costs, or paying for a child’s college education or other debts at a lower interest rate. Mortgage interest is also tax-deductible, as opposed to most other kinds of loans.
While it does make sense on paper to cash out on a loan with lower interest, this type of refinance can lead borrowers to sink deeper into the “debt trap.” When credit is freed up, new loans are usually acquired. This leads to wasted fees paid for refinancing, lost equity, additional years of increased interest payments, and the return of high-interest debts (like credit cards).
The Wild Cards
Refinance Fees
Much like securing your original mortgage, a refinance involves a laundry list of closing costs. You’ll need to pay things like title insurance, transfer fees, attorney costs, appraisals, taxes, and more. While some banks advertise “no closing costs,” be aware that most lenders will ultimately recoup those costs through an increased interest rate.
The point at which the cost refinance fees is outweighed by the savings from your new loan is called the breakeven period. Use a breakeven calculator to analyze the numbers.
Old Habits
Refinancing to cash in on equity can be very helpful, or it can sink you further into debt. With cash in hand or credit freed up by debt payoffs, it’s easy to fall back into old patterns. When your equity is used to acquire more high-interest debt, any financial benefits of your refinance are nullified. Cash-out on equity only if you’re certain you can resist the temptation to slip back into debt.
While you assess your options, it’s important to be honest with yourself: what is refinancing going to do for your long-term financial health? Is it really the best option? It’s always a great idea to weigh the costs and benefits with a trusted financial advisor if you’re feeling unsure.
