Are you considering a mortgage refinance but unsure if it makes financial sense? Whether you’re looking to get a more affordable monthly payment, lower rate, change the loan term or pull cash from your equity, there are factors to consider before applying. This guide explores different scenarios to help you determine when a mortgage refinance makes the most sense and when it’s not the best option.
How Much Can You Get by Refinancing?
Some homeowners choose to refinance their mortgages to access cash. Through a cash-out refinance, you may be able to borrow up to 85 percent of your home’s equity.
To illustrate how it works, assume your home is worth $450,000 and you owe $250,000 on the mortgage. You could potentially pull out $132,500 in cash ($450,000 * .85 – $250,000), and your old loan would be replaced with a new one for $382,500 ($250,000 + $132,500). This is equivalent to the existing balance plus the amount of cash you pull out). Going forward, you’d make payments on the new loan until it’s paid in full.
How Do You Know If It Is Worth It to Refinance Your Mortgage?
Before deciding if refinancing your mortgage is worthwhile, evaluate the reasons for wanting to move forward. Also, run the numbers to determine if it makes sense and gets you closer to achieving your financial goals.
When Should You Refinance Your Mortgage?
Here are some common reasons why refinancing your mortgage could be good for your financial situation.
If You Want Your Interest Rate Lowered
If market conditions have caused a reduction in average market rates, you can take advantage by refinancing your home loan. A slight decrease could equate to thousands of dollars in cost savings.
For example, assume you have an outstanding balance of $140,000 on a 30-year mortgage with a 5.5 percent interest rate and 20 years remaining on the loan term. You apply to refinance, and the lender offers you a 4.75 percent interest rate with a 20-year loan term. You’ll enjoy $70,868.86 in interest savings over the loan term.
If You Want to Change Your Loan Terms
An extended term gives you more time to repay the loan, which usually means smaller monthly payments. However, it also means you’ll likely pay more in interest as the lender will have more time to collect it from you. Furthermore, the lender may offer you a higher interest rate if you opt for a lengthier loan term to account for inflation. Still, refinancing to get a longer term could be worthwhile to get the relief you need if your monthly mortgage payment is unaffordable. You’ll also have more cash at your disposal to meet other pressing financial goals, like paying down high-interest debt, beefing up your retirement fund, investing to build wealth, boosting your monthly savings or creating an emergency fund. More on these shortly.
But if you want a shorter term to pay off the loan faster, mortgage refinancing can help you accomplish this objective, but you’ll likely get higher monthly payments. The upside is you could get a lower interest rate and enjoy reduced borrowing costs or pay less interest over the life of the loan. Before moving forward with a refinance to reduce your mortgage term, assess your spending plan to ensure you can comfortably afford the new payment amount. Otherwise, you could be doing more harm than good to your financial health.
If Your Credit Score Has Increased
The most competitive interest rates on home loans are generally reserved for borrowers with good or excellent credit health. A high score means you’ve managed your past and current debt obligations responsibly and are less likely to default on your loan payments. In turn, the lender will reward you for your efforts by offering a lower interest rate.
If your credit score wasn’t on the higher end when you initially applied for a mortgage, there’s a chance you didn’t qualify for the best rate available. However, an increase means you could potentially qualify for a better rate, particularly if your score is higher than it was when you took out your current mortgage and average interest rates are lower or around what they were.
If You Want to Pay Off High-Interest Debt
High-interest debts can easily stretch your budget thin, especially if you have several with hefty outstanding balances. And if you can barely afford the minimum monthly payments, chances are you’ll be buried in a mountain of debt for some time.
However, tapping into your home equity through a cash-out refinance means you can possibly repay creditors at once and break the chains of debt bondage. You’ll also save a sizable amount in interest. To illustrate, assume you have a credit card with a $15,000 balance and a 19.99 percent interest rate. If the minimum monthly payment is $375 and it’s all you can afford to pay towards the balance, it’ll take 67 months to pay the balance in full. Plus, you’ll pay a whopping $9,914 in interest. Or you can use a portion of the proceeds from a cash-out refinance to pay it off and use the $375 for another important financial goal.
In case you aren’t aware of how a cash-out refi works, it’s a home loan product that lets homeowners convert a portion of their home equity into cash. So, if your home’s value is $425,000, you owe $215,000, and the lender lets you pull 80 percent of your equity out, you can access $125,000 ($425,000 * .8 – $215,000) in cash. Your current loan would then be replaced with a new one for $340,000 ($215,000 + $125,000), which includes the original mortgage balance plus the amount of equity you pull out.
If you’d prefer not to pull cash from your home, you can also refinance to extend the loan term and use the funds you free up to make extra payments towards the debt balances.
If You Want to Renovate Your Home
A cash-out refinance is also a popular choice amongst homeowners with a sizable amount of equity to fund home renovations or much-needed repairs. It can be costly over time to cover the expenses on a credit card, and you’ll find that refinancing means your interest rate will be substantially lower. Another benefit is the potential to significantly increase the value of your home by making upgrades. Be sure to obtain quotes from contractors before moving forward to avoid pulling out more cash than you need and taking on unnecessary debt.
If You Want to Invest the Money
You can also pull funds from your home equity through a cash-out refinance to expand your investment portfolio of stocks, bonds or other assets. Another way to invest the money is by making much-needed home repairs or upgrades to increase its value, leading to a higher profit margin if you decide to sell the property soon.
If You Want to Get Rid of PMI
If you have a conventional mortgage, it’s not necessary to refinance to eliminate private mortgage insurance (PMI). Instead, you can reach out to your mortgage lender to request that it be removed once there’s at least 20 percent in equity in your home.
FHA loans are another story – they come with mortgage insurance premiums (MIP) that remain intact for the life of the loan unless you refinance into a conventional mortgage. (An exception to the rule applies if you made a down payment of 10 percent or higher. In this case, the MIP will fall off after 11 years of mortgage payments).
When Shouldn’t You Refinance Your Mortgage?
Unfortunately, there are also circumstances when refinancing may not be the best option.
If You’re Moving Out
Relocating can be an exciting time, especially if it’s for a good reason. However, it also means that you may want to hold off on refinancing, or you could lose money on the deal.
If You Have Other Home Equity Loans
Some lenders will deny your mortgage refinance application if you have outstanding home equity loans, home equity lines of credit (HELOC) or other claims against the property. So, inquire before refinancing to determine if you’ll need to pay the balance(s) in full to get approved.
If You Just Want to Splurge on Purchases
Will refinancing put you in a better financial position? If not, or if you’re simply looking for extra funds to splurge on unnecessary purchases, it’s best to hold off.
If You’ve Almost Paid Off Your Mortgage
A quick glance at your mortgage amortization schedule will reveal that a bulk of your monthly payment at the beginning of the loan term is applied to interest. Once you’ve paid for some time, though, more is applied to the principal, resulting in an increased amount of equity. Unfortunately, it also means refinancing could reset the loan term, and the cost savings wouldn’t be as significant as they would have been if you’d refinanced much earlier in the loan term.
Is Refinancing Your Mortgage Right for You?
No matter the reasons why people choose to refinance their homes, you need to consider your circumstances to understand if refinancing is right for you.
Check Your Finances
Do the benefits of refinancing outweigh the costs? Use a refinance calculator to run the numbers and determine if swapping out your current mortgage for a new one makes financial sense. Be sure to account for the lender’s origination fee (if applicable), the credit report fee, the home appraisal fee, the title search and title insurance fee, and the document preparation fee.
On average, borrowers spend between 3 percent and 5 percent of the loan amount on closing costs, depending on the location. So, if you’re refinancing your current mortgage with a balance of $475,000, you’ll spend roughly $14,250 to $23,750.
Understand What Refinancing Means for You
Are you familiar with how refinancing works? Then, be sure to get familiar with the process and explore all your options, along with the benefits and drawbacks of each, to determine if you should apply. As mentioned above, it involves swapping out your
existing mortgage with a new one, possibly with better terms. Most homeowners refinance to get much lower monthly payments, pay their home loan off faster or tap into the equity they’ve built up.
Time It Properly
Is it a good idea to refinance, or should you hold off until it’s the right time? Maybe mortgage companies are offering higher rates, or you want to improve your credit score or save up a bit more for closing costs before you refinance. Either way, be sure it’s the best time to refinance to maximize the benefits.
