If you are a homeowner, chances are you’ve received emails or physical mail advising you to refinance your mortgage, but many Americans don’t understand exactly what this process entails. Before taking the leap, learn more about what it means to refinance your loan and whether or not it’s right for you.
What is refinancing?
Put in simple terms, refinancing a loan means paying it off and replacing it with another one. That means you could end up with a lower interest rate than you had on your initial mortgage, as well as a shorter term. Investopedia.com also mentions that refinancing might make sense for borrowers with an adjustable-rate mortgage who want to lock in a lower, fixed interest rate on their loan.
Reasons to refinance
Holden Lewis, assistant managing editor and mortgage analyst at Bankrate.com, lists two main types of refinances.
The first one relates to the desire to save money on an existing loan. Named rate-and-term refinancing, this option makes sense if you can find a loan at a lower interest rate than your current one and at a term you can afford. Lewis points out the importance of calculating your “break-even point,” which he describes as “the time it will take for the mortgage refinance to pay for itself.” Divide the total closing costs of your new loan by the total amount you’ll be saving per month to see your break-even point. For example, if you paid $3,000 in closing costs and will save $100 per month with your new loan, it’ll take you 30 months, or 2 and a half years, to start seeing gains.
The second type of refinance is called cash-out refinancing. In this scenario, you would take out a new mortgage for more than you currently owe on your house. This allows you to pocket the difference and use the money how you see fit, such as to pay off other loans. However, Lewis warns against this type of refinancing, as “you may pay thousands more in interest because you’re taking up to 30 years to pay off the balance you transferred from your credit card to your mortgage.”
Reasons not to refinance
While it might sound wonderful to refinance your mortgage, it might not be the best option for you. Ashley Eneriz, contributor to Time.com Money, lists some scenarios in which you should stick with your current loan.
If you plan on moving anytime soon, it’s not a wise decision to refinance your mortgage. “Selling too soon after refinancing means you won’t live in your home long enough to capture the savings benefits of lower rates. Plus, you’ll still owe any fees associated with the new loan,” explains Eneriz.
When considering a refinance, it’s important to look at the type of loan available. If your best option is an adjustable-rate mortgage and you currently have a fixed rate, think twice before signing any paperwork. “Adjustable rate mortgage (ARM) rates are tempting to jump on, especially since they guarantee a low rate for a certain amount of time,” writes Eneriz. “However, interest rates eventually will go up. It’s just the ebb and flow of the economy.”
Finally, Eneriz advises you to consider whether you are truly in a good financial position to refinance your mortgage. If you have seen the value of your house drop considerably since you originally financed it, you could have to pay private mortgage insurance, or PMI, on top of your new loan. Additionally, a negative change in your credit score can affect the type of interest rates you qualify for. In this case, you might have a better interest rate sticking with your current one than you would refinancing.
If you are thinking of refinancing your mortgage, talk to your financial institution to see what options are available and to discuss whether or not it’s in your best interests to switch.