Refinancing your home is a useful tool that can help you make the most of your investment. However, you should carefully examine your goals and circumstances to determine if it is the right choice for you. Read on to learn more about the pros and cons of refinancing your home.
What is home refinancing?
Refinancing a home involves trading your current mortgage for a new one with different terms, including a new interest rate or a different balance.
The amount of equity you have built-in your home as well as your current financial situation can influence your eligibility for new mortgage terms. Most people refinance for one of the following reasons:
Top Reasons for Refinancing Your Home
- To lower your interest rate
- To finance a home renovation
- To finance a new investment property
- To eliminate existing mortgage insurance
- To consolidate your debt
There are upsides and downsides to refinancing, and they can vary from person to person. We recommend looking at these common pros and cons and considering how you might be affected if you choose to refinance.
Home Refinancing Pros and Cons
Should I refinance my mortgage?
The decision to refinance will be unique to you, your goals, and the type of mortgage you have. Unfortunately, there is no hard and fast rule of thumb. Instead, analyze your circumstances and ask yourself some important questions:
1. Do I plan to move in the next few years?
If you plan to sell your home in the next few years, refinancing might not save you money. You need to calculate the refinancing costs and determine when you will reach your break-even point.
To find this, divide the total loan costs (bank fees, title costs, attorney fees, and escrow charges) by your monthly payment savings to determine how many months you need to stay in your home to recoup these expenses. Otherwise, refinancing could cost you more.
2. What type of mortgage do I have?
Your mortgage either has a fixed rate or an adjustable-rate (ARM). If your mortgage is fixed, your interest rate will be locked in based on the Federal Reserve Rate at the time your mortgage began.
If it is variable, it will fluctuate based on a formula. That formula may include a lower interest rate for a certain number of years then will fluctuate.
People often refinance their mortgage to lock in a lower fixed rate or switch from an ARM to a fixed-rate mortgage that will be more predictable and affordable.
3. What is the current Federal Reserve Interest Rate?
If the current Federal Reserve Interest Rate is much lower than the rate you are paying with a fixed-rate mortgage or you have an opportunity to get a new fixed-rate mortgage that will be locked in at a historically low rate, refinancing is an opportunity to take advantage of that.
4. What is my number one reason for refinancing?
“I want to refinance for a lower interest rate.”
One of the primary reasons to refinance your home is to save money with a better interest rate. Many advise refinancing when you can save at least 2% on your existing loan, but there may be reasons to refinance for 1%.
Reducing the interest rate on your home loan helps you build equity faster and lowers the overall amount you will pay on your mortgage over time. It can also lower your monthly payment. However, most financial advisors would say that if your current monthly payment is affordable, you should continue paying the same amount after refinancing. This will help you build equity as quickly as possible.
“I want to refinance to cash in on my equity.”
Many people choose to refinance to pull out the equity they have built to finance other things like home repairs, college costs, a new baby, buying new investment properties and more.
By pulling some or all of your equity out of the mortgage, you are resetting it to zero, which may work well if you have a good credit score and can afford it.
“I want to refinance to shorten the loan terms.”
The most common mortgage term in the United States is 30 years. Meaning the borrower has 30 years to pay off the mortgage. However, most people do not keep their original mortgage this long. Within ten years, most have sold or refinanced their home.
When you refinance to shorten the loan terms of your mortgage, you agree to pay off the loan faster, which usually means taking on a higher monthly payment.
This strategy is best for borrowers who can afford to pay more monthly. It also helps to have a low debt-to-income ratio to prove to the lender that they can afford it. In general, you’ll want your DTI to be under 36%.
“I want to use equity to consolidate my debt.”
If you have a lot of high-interest debt like personal loans and credit card bills, using your equity to consolidate that debt may help you save money and simplify your debt repayment.
Mortgages typically have much better interest rates than credit cards or unsecured loans.
“I want to get rid of my existing mortgage insurance.”
Private mortgage insurance can add hundreds of dollars to your monthly payment. This insurance typically protects the lender and may require borrowers deemed a higher risk by the lender.
If your creditworthiness has improved, it makes sense to refinance your mortgage so you can eliminate this insurance.
The Most Common Type of Home Refinancing
By far, the most common way to refinance your home is to switch from an adjustable-rate mortgage to a fixed-rate mortgage. This works best when you can lock in a historically low-interest rate.
Unfortunately, fixed-rate mortgages may be more challenging to qualify for than variable ones. Refinancing to take advantage of a better interest rate may not be an option for borrowers experiencing financial pressure, hardship or crisis.
If you are experiencing financial hardship, mortgage relief and other debt-relief options can be the first line of defense that is more accessible than refinancing.