With today’s low interest rates, it’s hard not to sit there and weigh the pros and cons of refinancing your home. The pros—lower monthly payments, paying less interest long-term and getting out of debt faster—all amount to one thing: More money in your pocket. So, what are the cons? We talked to Caroline McCarthy, Vice President at Own Up, a service that helps you nab the best deal on your mortgage, as well as a couple of actual homeowners who recently refinanced, to help you pinpoint the right choice for you.
First, what does it mean to refinance your home?
When you refinance your home, this means that you are replacing your current mortgage with a new one—and typically one that comes with a better rate. It works like this: In most cases, you need a mortgage to pay for your home. The money you get via the mortgage goes straight to the home seller, which means, in turn, you have a loan from the bank that you pay back in monthly installments plus interest over a fixed period of time. But if you decide to refinance, your new mortgage pays off the balance of the old one and you are left with a new mortgage, typically with a lower monthly payment than your old one. (Note: The refinancing process requires you to qualify for a loan and do all the paperwork, just as you did the first time around.) But is it worth it? Let’s take a look.
The Pros of Refinancing Your Home
The benefits of refinancing can be vast. Here, McCarthy explains the nuts and bolts of each one.
1. You can lower your interest rate
The rates at the start of the COVID-19 pandemic are no longer at rock bottom, but you can still secure a much-reduced monthly interest rate, particularly if you first secured your home at a higher rate. (Current rates are hovering around 3 percent.) Per McCarthy, a good rule of thumb when it comes to refinancing is to proceed only if you can drop your interest rate by at least 0.25 percent. “Lowering your interest rate by 0.25 percent or more can result in substantial savings—sometimes as much as tens of thousands of dollars over the life of the loan—with the exact amount based on the drop in interest and any applicable closing costs,” she says.
2. You can reduce your monthly payments
Just make sure the reduction is meaningful enough to make the hassle and various fees worth it. One homeowner we chatted with said, “I had to run the numbers a few times to make sure that refinancing would be worthwhile for us, since you still have to pay closing costs. But, as the rates continued to dip, we realized we could save $400 a month by refinancing and make up the difference in closing costs in less than a year’s time.” McCarthy adds: “According to Freddie Mac, refinancing fees total 2 to 3 percent of the mortgage. Divide the total fees of the refinance by your monthly savings to get the number of months to break even.”
3. You can shorten your loan term and total payment
For example, a homeowner might want to refinance in order to change the term of their current mortgage from a 30-year to a 15-year term. Even if has little effect on your monthly payments, it could still turn out to be advantageous in the long run since you’re out of debt faster than originally planned. “Mortgages with shorter terms generally have lower interest rates and borrowers pay a higher percentage of their monthly payments to principal earlier on,” says McCarthy.
4. You can switch from an adjustable-rate mortgage to a fixed rate
Since ARMs tend to fluctuate, if rates suddenly rise significantly, it can cost you more in the long run. “If you’re planning to stay in your home for a long time, switching to a fixed-rate mortgage may save you money over time and give you the security of a fixed rate,” McCarthy explains. (If you can lock it in when it’s still hovering near an all-time low, even better.)
5. You can get rid of private mortgage insurance
Borrowers are required to take out private mortgage insurance (PMI) if they are getting a conventional mortgage and have a down payment of less than 20 percent. This can add hundreds of dollars to your monthly payment. “If mortgage rates have dropped since you bought your house and your equity has increased, refinancing might result in a loan-to-value ratio below 80 percent, which allows you to get rid of PMI,” says McCarthy. (If you have an FHA loan, refinancing to a conventional loan is the only way to get rid of mortgage insurance, she adds.)
6. You can secure money for home improvements
This is where the “cash-out” refinance comes in. The idea here is that you replace your existing mortgage with a new home loan for more than you owe on your house. Any difference above what you owe gets paid out to you in cash that you can use to renovate or remodel or simply repair the roof. In order for this to be approved, you have to have enough equity (for the amount you’re cashing out) built up in your home.
The Cons of Refinancing Your Home
Before you dive in head-first into a refinance, keep in mind, there are a couple of reasons where it’s simply not worth it.
1. Your monthly payment savings will be negligible
As we mentioned in the pros, if the savings associated with your refinancing don’t have a meaningful impact on your financial well-being, leave everything as is. Per McCarthy, you have to calculate the long-term impact. “Refinancing will reset the amortization period, which means that if you’re five years into a 30-year mortgage, you’re restarting the clock,” says McCarthy. “This increases the overall amount you pay in interest as you are spreading payments out over a longer term than your existing mortgage and the percentage of your monthly interest payment is highest at the beginning of the loan term.” If it costs you more in interest payments long-term, you should skip.
2. You’re planning to sell your home and relocate
Says McCarthy, “When paying closing costs, you need to be certain you’ll be in the new mortgage for a long enough time for the savings to exceed the upfront cost to refinance.”
If Refinancing Isn’t Right For You, There Are Still Ways to Save
Refinancing makes the most sense for borrowers that fit into the buckets listed aobve. But if that isn’t you, don’t get discouraged—there are other options to consider. McCarthy maintains that it’s also smart to make extra principal-only payments. These go directly towards the principal and reduce the interest you would pay. “Just because your mortgage has a fixed-interest rate doesn’t mean you can’t pay ahead and make principal-only payments,” McCarthy says. “Few mortgages have a prepayment penalty, but if yours does, it would be shown on your loan estimate.” The benefit of paying ahead of schedule cuts down your interest over time and the savings can actually exceed refinancing, which comes with fees.
Bottom Line: Do Your Homework
If you’re interest in refinancing, you have to shop around. “The rate and fees you’re offered on your mortgage can vary widely from lender to lender, even for the exact same loan parameters on the exact same day,” says McCarthy. The more you explore your options the better your deal will be. Also, try not to be daunted by the task. Another homeowner we chatted with explained: “We were really pleased with our refinance, which saves us about $300 a month in payments. Yes, there’s a lot of paperwork and tracking down bank statements, but it’s nothing like the work of getting an initial mortgage. Plus, at the end, we got a month with no mortgage payment, since it was wrapped up in the closing costs.” A win-win.