Refinancing your home can be a useful tool for a number of reasons. It can lower your monthly payment and free up cash to make home improvements or pay off debts. But it’s not the right choice for every homeowner, so be sure refinancing makes sense for your own situation.
When you refinance your home loan, you swap out the existing loan for a new one that has a different interest rate, monthly payment, and in some cases, a different term length. Many homeowners refinance to take advantage of interest rates that may have dropped since taking out their first mortgage, resulting in a lower monthly payment. Others refinance to access their home’s equity to pay for major improvements or to pay down other debts that have a higher interest rate, like credit cards.
Refinancing comes with a base fee and some upfront expenses, such as a home appraisal and closing costs, so it’s important to look at your options to determine if refinancing is your best choice. Let’s take a closer look at refinancing and the reasons for doing it:
How refinancing works
When you refinance your home loan, you pay off the existing mortgage and substitute it with a new loan. Generally, this happens in one of two ways:
- Rate and term refinance: Your original home loan is replaced with a new loan that has a lower interest rate or different length of term.
- Cash-out refinance: This option allows you to take some of the equity in your home as cash upfront. Your new mortgage will be for the amount remaining to be paid on your original loan, plus the amount of equity you took as cash.
You will apply for a new loan just as you did when you applied for your original mortgage. There is generally a base charge to refinance, usually between 3 percent and 6 percent of the original loan’s principal, and you’ll also pay for an appraisal and closing costs.
Reasons to refinance
Even with these initial costs, however, refinancing can often help you save money in both the short term and over the life of the loan. Let’s look at some of the reasons you might decide to refinance your home:
- Lowering your interest rate: A lower interest rate reduces your monthly mortgage payment. That immediately eases the strain on your monthly budget, which can also help you save more for other things, such as vacations or retirement. It also means you’ll build equity in your home more quickly.
- Shortening the term of your loan: If you’re fortunate enough to see interest rates fall after taking out your first loan, you might be able to take advantage by refinancing for a shorter term. If rates have fallen enough, you might be able to pay roughly the same amount per month but pay off your loan in a much shorter amount of time. As an example, if you have a 30-year fixed-rate mortgage on a $100,000 home, refinancing from 9 percent to 5.5 percent can cut your term down to 15 years, while your monthly payment would only rise about $15.
- Switching from an Adjustable Rate Mortgage (ARM) to a fixed-rate mortgage: In the first few years of an ARM, your monthly costs are predictable because of an initial fixed-rate period. But when this period ends (usually between 5 and 10 years after taking out the loan) you’ll be subject to an interest rate adjustment based on the current market. If rates rise, you’ll pay more, which could create havoc with your monthly budget and keep you from saving for other important goals. Converting to a fixed-rate mortgage can bring certainty back to your budget.
- Going the other way–from a fixed rate to an ARM: This strategy can save money if interest rates have fallen since you bought your home. Your future plans play a big part in this decision; if it’s likely you’ll move out of your home in the next few years, converting your fixed-rate mortgage to an ARM makes sense when interest rates have dropped.
- Paying for home improvements, education, or other major costs: If you don’t have access to other sources of cash, using the cash-out option to refinance your loan can help you here. Using your home’s equity to make improvements can pay off by boosting its value. Sometimes, it’s a wise choice to use your equity to pay for other large ticket items, like paying for tuition or medical bills, because the interest rate is lower than using a credit card or taking out a different kind of loan. Before using the cash-out option, it’s a good idea to get firm estimates on the costs you’re covering to make sure you don’t take out more money than you need (or take out too little, and be faced with paying the difference).
- To pay down debt: If you’ve accumulated a large amount of high-interest debt, like credit cards, using the cash-out refinance option to consolidate and pay off those bills might save you thousands of dollars. Again, weigh the upfront costs of refinancing against the amount of debt you hope to pay off. Also, examine your spending habits carefully. If you’re using the equity in your home to pay down debts, make changes going forward so you don’t wind up with additional debt in the future.
Should you refinance?
There are many scenarios where refinancing your home can improve your immediate and long-term financial picture, but everyone’s situation is unique. Consider these factors when making a decision on refinancing:
- How long you plan to stay in your home: Refinancing is usually a good choice if you’re going to be in your home for a long period of time. It could take several years to recoup the front-end costs of refinancing, so if you move within a few years, you won’t have time to realize those savings. The exception to this, as mentioned earlier, is if you’re converting from a fixed rate to an ARM.
- Long-term savings vs. upfront costs: It doesn’t make sense to refinance for a very small drop in your interest rate. Generally, you should hope to save at least 2 percent or more off your current interest rate for refinancing to pay off in the long run.
- Your credit score: If your credit score has improved since you got your first loan, you might be able to refinance and save money. Lenders generally have less risk loaning money to people with higher credit scores, so you may qualify for a lower interest rate when you refinance.
Refinancing can be used in a variety of ways to strengthen your overall financial situation, pay for large expenses, or make improvements that will enhance your home’s value. Understanding the steps involved in refinancing, the upfront costs, and the long-term benefits will help you decide if refinancing is the right decision for you.