If you’re a homeowner with budget troubles, someone has probably suggested that you refinance your mortgage. It can be a smart move for some people, but it’s not for everyone.
What is Mortgage Refinancing?
When you refinance your mortgage, you take out a new loan that pays off the original one. You then have a different mortgage with different terms.
What Is the Benefit of Refinancing Your Home?
According to Freddie Mac, a secondary mortgage buyer and leading advocate for home affordability, 83 percent of refinancing borrowers made the choice in order to tap the equity in their homes. This is known as a cash-out refinance, and its share of all refinance loans is the highest it’s been since 2007.
Your home equity is the portion of your home’s value that you’ve already paid off. One of the advantages of refinancing a home is that you can borrow against that equity. You get a percentage of it in cash form, but you have to pay that amount back to your lender with interest.
When Should You Liquidate Your Equity?
Many people use money from a cash-out refinance to pay off credit cards. Assuming you don’t start accruing more debt right after you pay it off, this can leave you in a better financial place.
- You can improve your credit card utilization rate, which is the percentage of your credit that you’re using.
- The average rate for a 30-year fixed mortgage is 17 percent. Even if you have excellent credit, your credit card interest rate is probably around 14.5 percent.
- You could save a lot by consolidating your credit card debt into a mortgage loan.
- Mortgage interest is tax-deductible. Credit card interest isn’t.
You might also use a cash-out refinance to fund home improvements. If those renovations will increase the value of your home and won’t saddle you with huge payments, you can really come out ahead. If you’re lucky, you can score a lower interest rate and even reduce your monthly payment.
When Not to Cash Out
When you do a cash-out refinance, the money you receive is added back into your mortgage. That leaves you with a higher overall balance and possibly a higher monthly payment, depending on interest and loan term. If you have to cut or reduce something essential from your budget to make that work, it’s not worth it.
Also, cash-out refinances come with fees, and those fees can be significant. You won’t get those fees back, so make sure the value that you’ll gain from the cash-out will be worth the expense.
Benefits of Refinancing a Home Without a Cash-out
Plenty of people refinance without cashing in on their equity. Usually, it’s because they can get a lower interest rate and a lower monthly payment to go along with it. You could save yourself a lot of money that way, but make sure that you read the fine print.
Potential Drawbacks of Refinancing
In general, you should be wary of refinancing if it would cause you to lose money in the long run. You should avoid any and all of the following situations:
Lower Payments, Higher Balances
When presented with the temptation of lower monthly payments, many borrowers get on board without thinking of amortization.
Most mortgages amortize, meaning that early payments primarily go toward interest. As the borrower pays off the loan, less interest accrues and more of the payment goes toward the principal.
If you pay less in the early days of your new loan, you won’t pay the balance off as quickly and interest will accumulate.
“Introductory” Interest Rates
Don’t get taken in by refinancing offers with low introductory rates. That introductory period won’t last forever and if market rates rise, you could find yourself with monthly payments that are beyond what you can afford.
That said, if you can pay off the mortgage before or shortly after rates go up, you might not want to let that opportunity get away.
This is a caution for any refinance borrower, not just those getting cash-outs. Refinancing involves the many closing costs inherent in any mortgage loan including:
- Title search and insurance (average $733)
- Attorney and closing fees (average $750)
- Property appraisal fee (average $480)
- Origination fee (1 percent of principal).
In addition to these standard costs for all mortgage borrowers, you may also be required to pay a reconveyance fee to your original lender and a local recording fee for your township to update your mortgage information. If these fees add up to more than what you’d be saving by refinancing, reconsider moving forward with the process.
When Should You Refinance?
Some people do find themselves in ideal circumstances for refinancing.
You have an elderly parent who needs more help, so you decide to build an in-law suite (also known as an accessory dwelling unit) in your basement.
Construction will cost $50,000, so you shop around and find a cash-out refinance that will let you get that money from your equity. The loan you find also gets you a lower interest rate, so you save on your monthly expenses while adding value – and possible future rent income – to your home.
Other times, refinancing looks good but really isn’t.
Let’s say that you get an offer for a refinance that will save you $200 on your monthly payment. Your budget is tight so you accept, even though the new loan means you’ll be paying off your mortgage longer and may pay more overall if you don’t make early payments.
A year later, you find out that you have to move. Because you’re paying less per month, you have more left on your mortgage than you would have otherwise. You find that your home is actually worth less than what you owe, so you’ll be in the negative when you sell.
Are There Alternatives to Refinancing?
Let’s assume that you’re considering refinancing because you need cash or are having trouble affording your mortgage payments. If you need cash, you could apply for a home equity loan or a personal loan instead of refinancing your mortgage.
If it’s your mortgage itself that’s straining your finances, you might want to consider not having one. You might not want to consider this option because you love your home and don’t want to move out, and that’s understandable.
The Best of Both Worlds
With a sale-leaseback, you don’t have to choose. Through a sale-leaseback, you can sell your home, converting home equity into cash and releasing you from your mortgage. But instead of moving out, you become a rent-paying tenant and can stay until you choose to move or re-purchase your home.
Refinancing can be a great way for you to get some cash and/or secure a mortgage with more favorable terms, but it doesn’t always work out that way. Don’t feel like you’re stuck between that, taking out another loan entirely, or moving.