Q: Many of my friends have refinanced their mortgage recently, and they’re urging me to do the same thing. Money is always a bit tight, and the thought of an extra few hundred dollars a month is very tempting. Should I refinance?
A: Refinancing a mortgage is essentially paying off the remaining balance on an existing home loan then taking out another mortgage. The second mortgage is usually at a lower interest rate. It may sound like a no-brainer, but there are lots of factors to consider before deciding to refinance.
Why people refinance
There are many reasons homeowners choose to refinance their mortgage. Here are some of the better ones:
1. To take advantage of lower interest rates
The first, and most obvious, reason homeowners refinance their mortgage is to take advantage of a lower interest rate. The drive behind this reason might be a change in finances, personal life or simply the desire to save money.
The accepted rule of thumb has always been that it was only worth refinancing if you could reduce your interest rate by at least 2%. Today, though, even a 1% reduction in rate should be reason enough to refinance.
Reducing your interest rate has several advantages. There are benefits beyond building more equity in your home sooner. You can also decrease the size of your monthly payment and, of course, save lots of money overall.
Say you have a 30-year fixed-rate mortgage with an interest rate of 5.75% on a $200,000 home. Your principal and interest payment is $1017.05. If you’d refinance that same loan at 4.5%, your monthly payment would drop to $894.03
2. To shorten the life of their loan
People sometimes choose to refinance their mortgage because they want to finish paying off their loan sooner. Refinancing can help you pay off your loan in half the time without changing your monthly payment much. This option can be especially helpful if you have a really high interest rate.
3. To convert between adjustable-rate and fixed-rate mortgages
Homeowners often opt for an Adjustable Rate Mortgage (ARM) because of the lower rate it offers. Over time, though, adjustments can increase these rates until they top the going rate for fixed-rate mortgages. When this happens, switching to a fixed-rate mortgage can lower the homeowner’s interest rate and offer them stability instead of future rate increases.
On the flip side, when interest rates are falling, it often makes sense to convert a fixed-rate mortgage to an ARM. This ensures smaller monthly payments and lower interest rates without refinancing every time the rate drops. This is not advisable in the current climate, since interest rates are more likely to climb rather than decrease.
When refinancing your mortgage is a bad idea
In certain circumstances, the worst thing you can do for your financial situation is refinance your mortgage.
- When you’re in debt. If you’re looking for the extra stash of cash each month to pull you out of debt, you probably shouldn’t be refinancing. Most people who refinance for this reason end up spending all the money they save, and then some. Without making any real changes to your spending habits, giving yourself extra money to blow is only enabling you to fall deeper into debt.
- When a refinance will greatly lengthen the loan’s terms. You won't come out ahead if you have 10 years left on your mortgage and want to refinance over 30 years. The money you save on lower payments will be lost in refinance costs and the extra 20 years of interest.
- When you don’t plan on living in your home much longer – If you plan on moving, the money you save might not come close to what you paid for your refinance.
What is a cash-out refinance?
Sometimes, homeowners choose to refinance to tap into their home’s equity and get their hands on a large sum of cash. To do this, they’ll need to refinance with a bigger loan so they can pocket the difference. However, they will need to stay within the loan-to-value, or LTV, threshold of their loan program. The LTV is the mortgage amount divided by the appraised value of the property.
For example, say you own a home that is worth $400,000 and you owe $240,000 on the mortgage. If your lender has an 80% LTV option, you could refinance into a $320,000 loan and take out the $80,000 difference in cash.
Cash-out refinances are a great idea if you need some cash for a home renovation, or to pay for your child’s college tuition. It’s best to choose this option only if you can afford the loan terms or will use that money to increase your equity. If you’re going to blow it all on a Caribbean cruise, you might be sailing toward a lifetime of debt.
How much will it cost?
Homeowners are often eager to request a refinance until they see what it will cost them.
Remember all those fees and closing costs you paid when you first bought your house? Prepare to pay most of them again. Broker fees will vary, but a typical refinance will cost anywhere between 3-6% of the loan’s principal.
Before proceeding with your refinance, make sure you’ll actually be saving money. You can do this by procuring a good faith estimate from several lenders. This will get you your projected interest rate and the anticipated loan price. Next, divide this price by the amount you’ll save each month with your anticipated new rate. This will give you the number of months that will have to pass before you break even from the new loan.
If you don’t plan on staying in your home for that long then refinancing may not make sense for you.