If you’ve noticed lower interest rates lately, you might be tempted to refinance. Lower interest rates are appealing and can lower your monthly payments—but that’s not the only factor to consider.
Deciding whether to refinance is just as financially important as arranging to buy a home. With a refinance, you’re replacing your old mortgage (or a first and second mortgage) with a new loan, so it’s essential to be on top of the situation.
Refinancing is best evaluated on a case-by-case basis. We’ll give you the facts about the pros and cons of refinancing so you can make the right choice for your home (and wallet).
- Refinancing your home loan can give you extra money for improvements or reduce your monthly payments.
- Refinancing restarts your loan clock and the amortization schedule (you pay off more interest than principal at the front of the loan).
- The risks and benefits depend on your financial situation and goals, as well as your credit score.
Pros and Cons
May reduce your payment
May stabilize your interest rate
Could allow you to pay off your home faster
Cash-out refi could fund home improvements or large expenses
Can allow you to get rid of a HELOC
Restarts your mortgage clock
Could raise your monthly expenses
Costs could outweigh benefits if you move soon
New appraisal could result in an upside-down mortgage
Requires good credit to get a lower rate
Cash-out refi could lead to overspending, risking your home
Pros of Refinancing
What’s a good reason to refinance? In some situations, refinancing makes sense.
May Reduce Your Payment
Refinancing into a lower interest rate may mean you’ll pay less over the life of your loan because a lower rate leads to less interest paid. However, that’s not the only potential benefit.
In many cases, you’ll see a smaller monthly payment if you refinance your mortgage to a lower interest rate and keep a 30-year mortgage term. Refinancing can help provide a little extra breathing room in your budget.
May Stabilize Your Interest Rate
If you have an adjustable-rate mortgage (ARM), future interest-rate increases can lead to a higher monthly payment down the road. A new fixed-rate loan will lock in the interest rate and monthly payment, making it easier to plan your monthly expenses.
Could Allow You to Pay Off Your Home Faster
If you refinance to a shorter time horizon, such as a 15-year loan from a 30-year loan, you can pay off your home sooner and own it outright.
This can also save you money in interest payments in the long run.
Could Fund Large Expenses with Cash-Out Refi
Depending on how much equity you have in your home, you might be able to get extra cash when you refinance. Refinance for more than you owe and take the extra money to pay down or consolidate debt, fund college, or start a new business.
If you refinance to perform home improvements, you may also be able to deduct some refinancing costs. Check with your tax advisor to discover tax-related refinancing pros and cons.
Can Allow You to Get Rid of a HELOC
With the permission of your lender, you could combine first and second loans on your home into one loan with the help of refinancing. This can streamline your payments and simplify your finances.
Consider refinancing your mortgage when current interest rates are at least 2 points below what you’re paying now, which helps your savings vs. costs pencil out.
Cons of Refinancing
Refinancing isn’t right for everyone. When is it a bad idea to refinance? It might not make sense to refinance if you consider the following.
Restarts Your Mortgage Clock
If you’ve already paid down your mortgage for five years, then refinance your home to a 30-year mortgage, the clock restarts. You pay off your house later rather than sooner. The more you’ve already paid off, the less sense it makes to refinance unless you’re moving to a 15-year mortgage.
Could Raise Your Monthly Expenses
Refinancing from a 30-year to 15-year mortgage can give you a higher monthly payment because you have a shorter period to pay off the mortgage. This can put a strain on your monthly cash flow.
You may also pay more if you refinance from a low-interest rate (yet unpredictable) ARM into a fixed-rate (and more predictable) loan. If rates rise in the future, though, you’ll pay less.
Costs Could Outweigh Benefits If You Move Soon
Refinancing typically incurs closing costs of around 3% to 6% of the mortgage and includes fees for loan origination, your application, appraisal, and more.
In these cases, it takes time for the interest savings to offset your upfront costs.
It might not make financial sense to refinance if you plan to move soon.
New Appraisal Could Put Your Mortgage Upside-Down
Your refinance is a mortgage designed to replace your current home loan, so the refinancing lender will probably require another appraisal. If the housing market isn’t doing well, you might have an “upside-down” loan or not have enough equity to refinance your home.
Requires Good Credit to Get a Lower Rate
Each lender has its own requirements for refinancing, but to get the best rate that makes refinancing an intelligent strategy, you’ll need good credit. According to FICO, credit scores of 670 or higher are considered good, very good, or excellent. If you have fair or poor credit, you could end up with a higher interest rate.
Cash-Out Refi Could Lead to Overspending
Even if a cash-out refinance can help you with expenses, it might not be a good idea if you’re using your home to get cash or refinancing to pay down unsecured debt such as credit cards.
Missing payments on cards can impact your credit score, but missing house payments could mean losing your home.
Additionally, research indicates that leaning on your home equity for quick cash when prices rise can lead to a higher debt burden if the housing market declines.
The Bottom Line
Whether mortgage refinancing is the right move for you depends on your goals, as well as how you move forward. There are multiple ways to refinance your home, and the pros and cons of refinancing largely depend on how you proceed—and whether the way you refinance is right for you.
Carefully consider the situation, weigh the pros and cons of refinancing, and then do it in a way that works best for your circumstances.