When times get tumultuous, your first instinct is probably to shore up the most important pillars in your life. Home and family mean everything, especially in uncertain times. If you were considering refinancing your home, you may be wondering if now is the time to act quickly on that process, or put it on hold.
Refinancing is a financial move where you pay off an existing loan and replace it with a new loan that has more favorable terms. Lowering your interest, shortening your mortgage length, or changing from variable to fixed-rate mortgage are common reasons why people may refinance their mortgage. But it’s not always the right solution, or the right time. Read on to learn whether this might be a helpful next step for you.
The Truth About Refinancing Your Mortgage
Note: First off, refinancing in the next few months of 2020 may be especially challenging. Due to coronavirus worries, many banks are loaded with far more requests for loan assistance than usual. It may take longer to find a lender who’s available, or willing, to work with you. It’s also difficult to predict what will happen with interest rates. Interest has been on the low end of historical ranges in recent years, which is promising for refinance. But in light of the rapidly changing response to COVID-19, it’s extremely difficult to say for certain what the impact will be on financial markets in coming months.
Fans of refinancing a mortgage say you can lower your interest, build equity faster, and save money in the long term. The truth is, while refinancing can be a smart homeownership move in some cases, it also cuts into your finances in the short term. You need to weigh the disadvantage of paying money now (e.g., closing fees) against securing a better deal for your home in the long run.
Refinancing rule of thumb
Common guidance says refinancing is only worth it if you’re saving at least 1% on your interest rate, and preferably 2% or higher. Otherwise, closing costs and the hassle of the process can outweigh the benefits of a slightly lower rate.
In addition to reviewing interest rate savings, the rule of thumb says refinancing is only worthwhile if you’re planning to stay in your home long enough. Compare closing costs against the amount of money you could save annually to determine how long it will take to break even.
Should I refinance to a 15-year mortgage?
If you refinance from a 30-year loan to a 15-year loan, your monthly payments may stay the same or even increase, but the benefit is you’d own your home free and clear much sooner.
If this is your reason for refinancing, the guidance about comparing closing costs to monthly or annual savings might not make sense for you. Instead, you’d review how much you could save over the life of the loan by reducing the duration. You should also pay attention to how your monthly budget will change, and whether you have the finances in place to pay the new mortgage even if you face an unexpected loss in income.
Types of Refinancing
People refinance their homes for different reasons. Some homeowners are interested in lowering interest rates or changing the terms of their mortgage. Others refinance in hopes of cashing out part of their equity to use toward other goals. Different types of refinancing will appeal to different families, depending on their reason for refinancing.
- Rate and term refinance: The goal here is to trade your mortgage for one with a lower rate, terms that fit you better, or both. Changing terms might mean switching from a 15-year mortgage to 30 years (or vice versa), or changing between adjustable and fixed-rate terms.
- Cash-out refinance: You refinance the mortgage to a higher balance and withdraw some of the equity of your home. Because your loan total increases, your mortgage payments may increase (although you might be able to offset some of that if you get a lower interest rate). A cash-out refinance loan is different from a home equity loan because you’re still sticking with one mortgage loan, instead of adding an extra home equity loan.
- Cash-in refinance: In this case, homeowners bring extra cash to pay in more equity on the home. In addition to the usual rate-and-term reasons for refinancing, increasing equity might help you eliminate mortgage insurance payments or qualify for better rates. Make sure you have fully funded emergency savings accounts before considering this option.
- Streamlined refinancing: Refinancing can be a lengthy process requiring credit checks and a detailed look at your finances. Some homeowners may qualify for a streamlined process that waives some of the typical approval steps and shortens the underwriting process. Streamlined FHA loans are one of the most common options.
Pros of Refinancing
For many homeowners, their home represents one of their biggest sources of wealth, and their largest debt. Managing your mortgage wisely can make a significant impact on your financial health.
Benefits of refinancing mortgage
The benefits of refinancing your home loan include the following:
- Lower interest rate: This can save you hundreds of dollars per year.
- More stability: An adjustable rate may start lower than a fixed rate, but fluctuations can send it much higher. Refinancing to a fixed rate may give you more predictability and security.
- Additional cash access: If you choose a cash-out refinance, you’ll have extra cash available for your needs.
- Updated mortgage plan: Maybe you’re earning much more than expected, and you want to shorten your mortgage term and own your home outright sooner. Maybe you’ve decided slow and steady is better for your family, so you’ve prolonged the loan for lower monthly payments. In either case, refinancing can align your loan terms with the structure that best fits your family.
Is refinancing worth it?
Refinancing is a complicated process, and it comes with its own expenses. Refinancing can be a useful tool at the right time, but it won’t fit every situation.
Refinancing to save 0.5% interest, for example, is unlikely to be worth the effort. Closing costs are likely to wipe out too much of the amount you’d save. If you’d save 1%, some lenders would say it’s worth proceeding. Other financial experts may advise you to aim for at least 2% savings.
Your total savings depend on a variety of factors. Checking a refinancing calculator online can give you an estimate of how much you might be able to save. Refinancing a $200,000, 30-year mortgage after 5 years to lower interest rates by 1% (from 5% to 4%) could save over $9,000 in interest over the life of the loan. Monthly payments would also go down by nearly $200. Check numbers with a financial professional to decide what savings cutoff makes refinancing a smart financial move for you.
Cons of Refinancing
Refinancing is far from a magical solution to financial woes. Refinancing the wrong way, or for the wrong reasons, can be a serious mistake.
Dangers of refinancing mortgage
Keep these risks in mind before refinancing your home:
- Expensive: Closing costs can range from 2-6% of the loan amount. If you’re refinancing a $200,000 mortgage, that’s $4,000-12,000! Cutting down your available cash is risky because it leaves you in a more vulnerable position if another unexpected expense comes up.
- Potential for greater debt: Some homeowners choose cash-out refinancing so they can pay other debts with home equity funds. If you pay off your credit card debt with home equity, but then max your cards out again, you’ll be worse off than before.
- Pay more interest: If you refinance to lower monthly payments as much as possible, you may end up paying more interest. If you were halfway through a 30-year mortgage and refinance to a new 30-year loan, you’ll start over spending years at the outset paying mostly interest, rather than principal. Your monthly payments may drop, but the amount you spend on your home overall may go up.
Does refinancing hurt credit?
The credit inquiry for refinancing approval will ding a few points off your credit score temporarily. Resolving the original mortgage loan can also affect credit, because you’re replacing an older loan with a new one. These are fairly small impacts, though.
Cash-out refinancing has the biggest potential to harm your credit. For one, you’ll have a larger debt-to-income ratio. You also have cash burning a hole in your pocket. Without a firm plan, you might be tempted to splurge and rack up more debt.
Ultimately, the slight credit score dips that come with credit checks aren’t the most important factor to consider. Refinancing changes your debt profile and may give you cash that could lead to more debt. Your spending habits matter much more than a temporary ding from a credit inquiry.
Refinancing your mortgage is one method to reduce the amount you pay into your home. If you treat it as a management strategy, and not a bailout tool, and if you consult a trusted financial advisor, you’ve got the best chance of finding a refinancing deal that pays off.