Paying off a current loan and replacing it with a new one is what refinancing a mortgage entails.
Homeowners refinance for a variety of reasons:
In order to get a lower interest rate,
In order to reduce the length of their mortgage,
Going from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage (FRM) and vice versa
Borrow against your home’s equity to cover a financial emergency, finance a significant purchase, or consolidate debt.
Because refinancing can cost anywhere from 3% to 6% of a loan’s principal and, like an original mortgage, needs an appraisal, title search, and application costs, it’s critical for a homeowner to consider whether refinancing is a good financial move.
Important Points to Remember
One of the biggest reasons for refinancing is to get a mortgage with a cheaper interest rate.
When interest rates fall, think about refinancing your mortgage to cut the length of your loan and save money on interest payments.
Depending on interest rates and how long you want to stay in your present home, switching to a fixed-rate mortgage—or an adjustable-rate mortgage—may make sense.
Other reasons to refinance your home include taking advantage of your home’s equity or consolidating debt, but be aware that doing so can sometimes make your finances worse.
Getting a Lower Interest Rate by Refinancing
One of the most compelling reasons to refinance is to lower your present loan’s interest rate.
According to the old rule of thumb, refinancing is a good choice if you can lower your interest rate by at least 2%.
Many lenders, however, believe that a 1% saving is sufficient incentive to refinance.
A mortgage calculator is a useful tool for budgeting some of the costs.
Reducing your interest rate not only saves you money, but it also speeds up the rate of building equity in your house and reduces the size of your monthly payment.
A 30-year fixed-rate mortgage with a 5.5 percent interest rate, for example, includes a principal and interest payment of $568 on a $100,000 home.
Your payment will be $477 if you take out an identical loan at 4.1 percent.
Shortening the loan’s term through refinancing
Homeowners may be able to refinance an existing loan when interest rates fall so that they can keep their monthly payment the same while getting a much shorter loan with a much shorter term.
Refinancing from 9% to 5.5 percent on a $100,000 home with a 30-year fixed-rate mortgage can reduce the term by half to 15 years while only slightly increasing the monthly payment from $805 to $817.
If you already have a 30-year 5.5 percent mortgage ($568), a 15-year 3.5 percent loan will raise your monthly payment to $715.
So do the arithmetic and see what you can come up with.
Converting to an ARM or Fixed-Rate Mortgage through Refinancing
While adjustable-rate mortgages (ARMs) typically start off with lower rates than fixed-rate mortgages, periodic adjustments might result in rate hikes that are larger than those offered by fixed-rate mortgages.
Converting to a fixed-rate mortgage when this happens results in a cheaper interest rate and avoids the risk of future interest rate hikes.
If interest rates are lower, changing from a fixed-rate loan to an ARM—which often has a lower monthly payment than a fixed-term mortgage—can be a good financial strategy, especially for homeowners who do not plan to stay in their houses for more than a few years.
These homeowners can lower their interest rate and monthly payment on their loan, but they won’t have to worry about how increased rates will affect them in 30 years.
If rates continue to decline, an ARM’s periodic rate adjustments result in lower rates and fewer monthly mortgage payments, obviating the need to refinance every time rates fall.
On the other hand, if mortgage interest rates rise, this would be a bad idea.
Refinancing to Take Advantage of Your Equity or Consolidate Your Debt
While the reasons for refinancing listed above are all sound financial reasons, mortgage refinancing can lead to an endless cycle of debt.
Homeowners frequently use the equity in their homes to pay for large expenses like home renovations or a child’s college education.
The fact that renovation adds value to the home or that the interest rate on the mortgage loan is lower than the rate on money borrowed from another source may be enough for these homeowners to justify refinancing.
The fact that mortgage interest is tax deductible is another justification.
While these arguments may be valid, increasing the number of years you owe on your mortgage or paying a dollar in interest to earn a 30-cent tax benefit is rarely a wise financial decision.
Also, if you acquired your home after December 15, 2017, the size of the loan on which you can deduct interest has decreased from $1 million to $750,000 thanks to the Tax Cut and Jobs Act.
Many homeowners refinance their mortgages in order to consolidate their debt.
Replacing high-interest debt with a low-interest mortgage appears to be a good option on the surface.
Regrettably, refinancing does not automatically imply financial wisdom.
Take this step only if you’re confident you’ll be able to resist the desire to spend once your debt is paid off.
It takes years to recuperate the 3% to 6% of principal that refinancing costs, so do it only if you plan to stay in your existing house for at least a few years.
Be mindful that many consumers who previously incurred high-interest debt on credit cards, vehicles, and other goods will easily do so again once their mortgage refinancing provides them with the necessary credit.
This results in a quadruple loss, which includes refinancing fees, lost equity in the home, more years of higher interest payments on the new mortgage, and the return of high-interest debt when the credit cards are maxed out again. This could lead to an endless cycle of debt and bankruptcy.
A major financial emergency is another reason to refinance.
If this is the case, thoroughly consider all of your fundraising choices before proceeding.
You may be charged a higher interest rate on the new mortgage if you conduct a cash-out refinance rather than a rate-and-term refinance, in which you don’t take out any money.
If refinancing lowers your mortgage payment, shortens the duration of your loan, or helps you develop equity faster, it can be a smart financial decision.
It can also be a useful tool for getting debt under control if utilized correctly.
Take a close look at your financial condition before refinancing and ask yourself, “How long do I plan to stay in this house?”
How much money would refinancing save me?
Keep in mind that refinancing charges anywhere from 3% to 6% of the original loan principal.
With the savings gained by a lower interest rate or a shorter term, it takes years to recoup that cost.
If you don’t plan on staying in your house for more than a few years, the expense of refinancing may outweigh any possible savings.
It’s also important to keep in mind that a smart homeowner is continually seeking methods to minimize debt, develop equity, save money, and pay off their mortgage.
Taking cash out of your equity when you refinance does nothing to help you achieve any of those objectives.