Refinancing a mortgage is the process of paying off your existing mortgage with a new one. A refinance incurs fees that typically total 2 to 5 percent of the loan’s principal, so anyone considering a refinance needs to ensure that the benefits will be worth the cost. Common reasons for refinancing a mortgage include the following:
- Lower rates/payments
- Shorter loan term
- Different interest type
- Using equity
A reduction in interest rate is one of the best reasons for refinancing your mortgage, provided the lower rates will pay for the closing costs of the new mortgage. A 2 percent reduction in the mortgage rate should be more than enough to justify a refinance, but a 1 percent reduction also may be sufficient depending on the terms of the new mortgage.
In addition to lowering interest costs, a reduced interest rate can enable you to decrease your monthly payments, which may be necessary when you suffer a financial setback. Assume for this example that you have a 30-year mortgage with a fixed rate of 5.5 percent and are able to refinance at 4.1 percent. The interest-rate reduction of 1.4 percentage points would lower your payments by about 16 percent.
Shorter Loan Term
You can use a refinance to reduce the term of your mortgage rather than lowering the payments. This situation typically occurs when interest rates drop but your personal financial situation remains unchanged. Assume for this example that you have a 30-year mortgage at 9 percent, which you refinance at 5.5 percent. You can reduce the term of your mortgage to 15 years by increasing your payments by only 1.5 percent.
Different Interest Type
Mortgages typically come with fixed or variable rates. Fixed rates never change, but variable rates fluctuate because they’re tied to a leading market indicator. Changing market conditions may allow you to save money by switching your mortgage from a fixed rate to a variable rate or vice versa. You may want to switch to a variable-rate mortgage if interest rates are falling while switching to a fixed rate would make more sense when rates are rising. Refinancing with a different type of mortgage is particularly beneficial when you plan to remain in your home for a long period of time, allowing the savings from the refinance to be fully realized.
Using your home equity as a source of cash, also known as a cash-out refinance, is a common means of paying down high-interest credit card debt. Cash-out refinances and other loans that are based on the equity in your home have comparatively low-interest rates because they are secured by the value of the home. Consequently, it may make sense to pay off your credit card debt with a refinance. However, you need to ensure that you won’t continue increasing the balance on your credit cards, because higher credit card debt might jeopardize your ability to make the payments on your refinance, leading to default and foreclosure.
Home repairs are another common reason for a cash-out refinance, especially if the expense is necessary to make the home livable. On the other hand, an optional renovation such as adding another bedroom rarely pays for itself when you sell a house. Be sure to research the likely return on investment (ROI) of a renovation before applying for a refinance.
When you start to wonder “should I refinance my mortgage?” there are important factors to consider. Talk to a financial advisor to determine if this is the right path for you.