When you refinance a mortgage, it means you pay off your existing loan and replace it with a new one. Homeowners choose to refinance for various reasons:
Lower Interest Rate: Getting a better interest rate on the new loan.
Shorter Mortgage Term: Changing to a shorter period for paying off the mortgage.
Switching Mortgage Type: Moving from an adjustable-rate mortgage (ARM) to a fixed-rate one or the other way around.
Accessing Home Equity: Using the home’s value to get funds for emergencies, big purchases, or consolidating debt.
Since refinancing involves costs ranging from 3% to 6% of the loan amount and requires tasks like an appraisal, title search, and application fees—similar to the original mortgage—it’s crucial for homeowners to decide if refinancing makes sense for their finances.
Refinancing for A Better Interest Rate
One top reason to refinance is to get a lower interest rate on your current loan. In the past, the general rule was that refinancing was smart if you could cut your interest by at least 2%. However, some lenders say even a 1% saving is a good reason. Using a mortgage calculator helps plan costs. Lowering your interest rate doesn’t just save money. It also boosts how fast you own your home and shrinks your monthly payment.
Refinancing to Cut Loan Time
When interest rates drop, you might refinance your current loan for another one with a much shorter time. Your monthly payment doesn’t change much, but you’ll pay off the loan a lot faster.
Refinancing to Switch Mortgage Type
Adjustable-rate mortgages (ARMs) often start with lower rates than fixed-rate ones, but they can go up later. Converting to a fixed-rate mortgage gets you a lower, stable rate, avoiding worries about future rate hikes.
On the other hand, if you’re not planning to stay in your home for long, switching from a fixed-rate loan to an ARM with a lower monthly payment could be smart, especially if interest rates are falling. This way, you benefit from lower rates without stressing about rates going up in the future.
Remember, when rates fall, an ARM’s adjustments lead to lower payments without needing to refinance often. But when rates rise, this strategy might not be wise.
Refinancing for Home Equity
Although the mentioned reasons for refinancing make financial sense, it’s important to avoid falling into continuous debt through mortgage refinancing.
Some homeowners use their home equity for big expenses like home improvements or education costs. They might justify this by thinking that improvements increase their home’s value or that the mortgage interest rate is lower than other borrowing options.