Refinancing a mortgage is a major move that can result in significant savings. But the strategy can also backfire, leaving you in a worse situation than you were in before—and with less money in the bank. So how do you know if you should refinance?
The short answer is that refinancing makes sense if you’ll end up saving money and if it won’t cause any new problems for you. But there are more considerations at stake, too, including risk management as well as your other financial goals. See whether your reasons for refinancing may help you or hurt you.
- Refinancing your home can be beneficial, but it's important to compare the costs and rewards involved.
- Homeowners most often refinance to save money, lower monthly payments, consolidate debt, or take cash out of their home equity.
- Refinancing comes with risks, though, such as losing equity, exposing your home to foreclosure, or facing prepayment penalties on your old loan.
- To decide on a refinance, add up all costs and risks involved in closing on a new loan and compare them to what you gain over the life of the new loan.
You can potentially save a lot of money with a refinance, and that’s generally the best reason to get one. In particular, refinancing may help you spend less in interest over the life of your loan.
There are several ways to reduce your interest costs:
- Refinance to a lower interest rate so that you pay less on your loan balance.
- Switch to a shorter loan term, even if it means higher monthly payments, so you pay interest for fewer years.
- Use your loan to consolidate high-interest-rate debts into lower-interest-rate debts.
To determine whether you’ll save money, you'll need to run the numbers. It’s not especially hard to calculate the potential savings of refinancing.
For example, if your current mortgage is a 30-year fixed-rate loan of $200,000 with a 5% interest rate, you'll have paid $48,076 in interest by year five, and you'll pay $186,512 in total interest over the life of the loan. If you refinance after five years to a 3% interest rate on a 30-year fixed, you'll only pay $95,252 in total interest on the new loan. Even added to what you have paid so far on the old one at the time of refinancing, you still come out ahead at $143,328 in total interest on your home—a savings of $43,183.
To understand why your timeframe matters, use an amortization chart that shows how much interest you pay with each monthly payment. On a brand-new long-term loan, the payments in the early years only make a small dent in your loan balance. If you refinance when you're just a few years into your current mortgage, most of the payments you've already made went primarily to interest. And if you sell before you break even on the new loan, you haven't saved yourself any money.
Lower Your Payments
Sometimes refinancing can net you a lower monthly payment. If you're having cash flow problems, a lower monthly mortgage bill can sound very appealing. A lower interest rate or a longer term could drop your monthly payment by hundreds of dollars.
Changing to an adjustable-rate mortgage (ARM) may lower your monthly payment, too. However, interest rates on these loans change over time, and if rates go up significantly, your payment could rise to an unaffordable level. You should refinance into an ARM only if you’re willing and able to take the risk of higher monthly payments down the road.
While it may be nice to pay less each month, make sure to look at the big picture. If smaller monthly payments are offset by increased interest costs, you aren't coming out ahead.
Reduce Your Risk
While saving money is an attractive reason to refinance, there are other reasons a new mortgage may be worth your while.
In some cases, refinancing might be a good idea even if you don’t get a lower rate or a shorter-term loan. Getting out of an ARM is one example. If you’re worried about significant interest rate increases in the future, refinancing from an ARM into a fixed-rate mortgage reduces that risk. Though your monthly payment may increase, you know the rate never will. Evaluate current rates on fixed-rate mortgages, your expectations for rate changes, and the potential for your existing ARM to change before refinancing out of an ARM.
Cash Out Your Equity
Some homeowners refinance to cash out the equity in their homes to pay for education, home improvements, or a new business. Although those are admirable uses, a cash-out refinance can be risky if your new business fails, your home improvements don't increase the value of your home, or if you can't keep up with tuition payments. In each of these cases, you've put your home on the line; be sure you can keep up with your new mortgage.
Consolidate or Shift Your Debts
You might also take cash out to consolidate high-interest-rate debts. If you have a solid plan to eliminate toxic debts, this strategy could work, especially since home loan rates are usually much lower than credit card interest rates. But if the plan fails, remember you may face the risk of losing your home in foreclosure or having your vehicle repossessed.
If you refinance unsecured debts with a secured loan, you’re taking additional risk. For example, you might use a home equity loan to pay off credit card debt. Yes, you’ll pay off the debt with a lower interest rate, but you’ve also put your home at risk. If you default on credit card debt, it’s unlikely that the credit card company can foreclose on your home. But once you pledge your home as collateral by using a mortgage loan, your home is fair game to the bank.
Remove a Borrower From the Loan
Whether you're going through a divorce or you've bought a home with a relative or friend, you may need to change who's officially responsible for paying the mortgage. Refinancing your mortgage is an opportune time to change what borrowers are listed on the loan. Be aware that the deed or title to the home doesn't automatically change when the mortgage does, so you may need to remove a name from that document as well. Be sure the closing costs and other assorted expenses associated with a refinance are worth the name change.
Eliminate FHA Mortgage Insurance
When you buy a home with an FHA loan, it comes with mandatory mortgage insurance. These mortgage insurance premiums (MIP) are payments you have to make each month for the life of the loan since these loans are made with very little collateral (as low as 3.5% down). With a traditional loan, ordinary private mortgage insurance (PMI) can be removed once you've achieved a certain amount of equity in your home; with an FHA loan, however, you'll have to refinance into a different loan altogether if you want to stop paying mortgage insurance.
What to Watch Out For
If you’re thinking it’s time to refinance, investigate the following:
- Closing costs, which will add to the expense of your loan. They may wipe out any gains you'd see from lowering your interest rate. It’s tempting to roll those costs into the loan balance, but it may be better to pay out of pocket so you don't pay interest on them, too.
- Prepayment penalties on the loan you will refinance into. Be sure you have the option to pay the loan off early if you want to.
- Private mortgage insurance, which may be necessary if your home has lost value.
- Whether you'll be turning a nonrecourse loan into recourse debt. If this happens, you may run the risk of your new lender garnishing your wages and taking other actions against you if you go through a foreclosure.
- Whether your equity will change. Taking cash out or adding significant closing costs to your loan balance will reduce your equity in your property. However, if you just replace one loan with another loan of the same size, your equity remains the same.
Evaluate whether your reasons for refinancing may outweigh the possible costs. If so, you can perform a basic breakeven analysis to see exactly what loan terms you need to find to make the new mortgage worth it.
Alternatives to Refinancing
Sometimes refinancing isn’t your best option—or it’s just not feasible.
You can still get some of the benefits of refinancing without going through the process. For example, if you want to save on interest costs, you can pay more than the minimum required each month. You'll get rid of your mortgage earlier, and you'll spend less on interest over your lifetime.