When and Why It Makes Sense to Refinance Your Home
With mortgage rates hovering at record lows, many homeowners find themselves asking the question: should I refinance my home? There are indeed several factors to consider and of course, no two situations are alike. You can perform this analysis yourself, or work with your personal banker or mortgage consultant to decide what works best for you.
Reasons to Refinance
Refinancing a mortgage means replacing — really, paying off — an existing loan with a new one. Let’s have a look at a few reasons why it makes sense to refinance a home.
To secure a lower interest rate
This is clearly the best reason to refinance: lower interest rates generally mean lower monthly payments, and who wouldn’t welcome that? Refinancing is usually a good idea if you can reduce your interest rate by at least 2%. However, many lenders say a reduction of even 1% can lead to savings that would justify a refinance.
Besides lower monthly payments, the other hidden benefit of a refi is the ability of the homeowner to increase the rate at which they build equity in their home. For example, a 30-year fixed-rate mortgage with an interest rate of 5.5% on a $200,000 home has a principal and interest payment of $1,136. That same loan at 2.8% reduces the monthly payment dramatically to $822 — paying less in interest and more of the principal.
To shorten the loan’s term
Another reason to refinance is to shorten the term of the loan. This helps build equity faster, with or without a dramatic increase in the monthly payment. Using the previous example of the $200,000 home, converting the 30-year fixed-rate mortgage with an interest rate of 5.5% to a 15-year fixed-rate mortgage with an interest rate of 2.4% increases the monthly payments from $1,136 to $1,324, a difference of $188. A monthly increase such as this can be seen by some homeowners as a cost-effective way of paying off their homes much faster than they could have with a higher rate.
To convert between ARM to fixed-rate, or vice-versa
Many homeowners start off with an adjustable-rate mortgage (ARM) because they often start out offering lower rates — and lower payments — than fixed-rate mortgages.
However, periodic adjustments can result in rate increases that are higher than the rate available through a fixed-rate mortgage. As such, homeowners can benefit from converting an ARM to one that is fixed-rate, in order to take advantage of lower interest rates and prevent surprises along the way.
On the flip side, when interest rates are falling, those in a fixed-term mortgage can benefit by converting their mortgage to an ARM. This works best for homeowners who do not plan to stay in their homes for more than a few years.
To access equity or refinance debt
Many homeowners refinance their mortgages because the money they save each month can be used to cover other major expenses, such as remodeling or renovation.
This is usually justified because remodeling adds incremental value to the home. Further, the cost of capital — the lower interest rate — would be less than that of another source they’d need to tap for financing.
Reasons Not to Refinance
While it might seem that there exists a sufficient number of reasons to refinance a mortgage in a low interest rate environment, there are a few considerations homeowners need to take before speeding ahead with a refi. Let’s have a look at a few of these.
A mortgage refinancing is not without its costs. As with the initial mortgage, refinancing requires that the homeowner pay closing costs that cover the charges for title insurance, attorney’s fees, an appraisal, taxes and transfer fees, among others.
These refinancing costs, which can be between 3% and 6% of the loan’s principal, can be the same or even higher than those paid for the initial mortgage. They might even take years to recoup. As such, these “hidden” costs need to be considered and factored into the new monthly payment. Indeed, the new payment may not necessarily be more attractive.
How long you plan to stay in your home
Related to closing costs, if you do not plan on staying in your home for more than a few more years, then a refi might not make sense. Homeowners need to figure out the optimal “break-even” point when closing costs will be paid off and they can enjoy the monthly savings from a reduced monthly payment.
It’s important to note that just because there might be historically low interest rates available, a new mortgage is not guaranteed at that low rate for every homeowner who applies for a refi. In fact, those with below-average or poor credit may not be able to take advantage of new, lower rates, and will not be able to enjoy a dramatic decrease in monthly mortgage payments.
If this is the case, it makes sense for homeowners in this situation to pay down debt, including making extra mortgage payments, in order to improve a credit score before considering refinancing their mortgage. Learn more about how SmartCredit can help you achieve your best score and set yourself up for more financial success.