Key Takeaways:
- There are a few types of refinance mortgages. Some allow you to cash out equity, and others provide a change in interest rates and terms.
- There are pros to refinancing your mortgage, including the ability to tap into equity, lower interest rates and redefine terms.
- In some cases, when you refinance your home, your monthly payment could go up and you reduce your home’s equity.
- When you take out a refinance mortgage, you pay off your original mortgage and the new one replaces it.
If you’re a homeowner, you may refinance your mortgage to take advantage of low interest rates, change your loan term or convert your home equity into cash. However, refinancing also comes with some drawbacks, depending on market conditions and your situation and financial goals. It’s important to fully understand the process before committing to a mortgage refinance. Let’s explore the pros and cons of refinancing a mortgage to see if this option is right for you.
Pros Of Refinancing Your Mortgage
Locking In A Lower Interest Rate
Securing a low mortgage interest rate is one of the most common reasons to refinance, especially if rates are lower now than when you first took out your mortgage. Lowering your interest rate can help you save money on interest payments over the life of the loan. Factors to consider before taking advantage of a low mortgage interest rate include:
- How long you had your existing mortgage
- The difference between your current and new mortgage rate
- How much you might spend closing on your new loan
Before choosing to refinance at a lower rate, talk with your lender about how much money you’ll actually save over time.
Eliminating Private Mortgage Insurance (PMI)
If you were unable to put down 20% on your original mortgage, you are likely making PMI payments each month. If you have enough equity to refinance into a new mortgage with a loan-to-value ratio (LTV) of 80% or less, you won’t have to pay it with your new refinance mortgage. If you refinance and do not meet the required LTV, you won’t be able to eliminate the PMI on the loan.
Paying Off Your Mortgage Sooner
Refinancing is a great option if you’re looking to shorten your loan term and pay off your mortgage sooner. For example, if you have a 30-year mortgage and 25 years left to pay it off, refinancing to a 15-year mortgage means you would pay it off 10 years earlier than anticipated.
The trade-off is that your monthly mortgage payments will be higher. But you’ll be paying more toward the principal balance and less in interest over the life of the loan. Plus, you’ll be building equity in your home at a faster rate.
Lowering Your Monthly Mortgage Payments
On the flipside, you may want to lower your monthly payments. Refinancing allows you to lengthen your loan term if you’re having trouble making your payments. The downsides are that you’ll be paying off your mortgage longer and you’ll pay more in interest over time. However, a longer loan term can make your monthly payments more affordable and free up extra cash.
Converting Your Home Equity Into Cash
As noted earlier, a cash-out refinance lets a borrower tap into their home equity and convert it to cash. If you meet the requirements for a cash-out refinance, you’ll borrow more than you owe on your mortgage and keep the difference in cash. Keep in mind that for most cash-out refinances, you need to leave at least 20% equity in your home and most lenders will let you borrow only up to 80% of your equity.
For example, let’s say you have $200,000 left on your mortgage and your house is valued at $300,000. That means you have $100,000 in home equity. Let’s suppose you’d like to use $50,000 of it for a few different things. You can use a cash-out refinance to borrow this $50,000 against the equity in your home. So, your new mortgage balance would be $250,000 ($200,000 + $50,000). You can then use this money to achieve various financial goals, like funding home improvements or renovations, consolidating debt or boosting a savings, college or retirement fund.
Removing A Co-Signer
If you were not able to qualify for a mortgage without a co-signer (someone who agrees to make payments if you cannot), you may be able to remove them when you refinance your original mortgage. When you refinance, you pay the original mortgage back in full and then assume the new loan terms, essentially absolving the co-signer of their fiscal responsibility for the loan. Note: You will have to qualify for a refinance on your own, which may be difficult for borrowers who needed a co-signer to qualify for a mortgage the first time around.
Switching To A Fixed-Rate Mortgage
If you have an adjustable-rate mortgage (ARM), which can come with fluctuating interest rates and unpredictable monthly mortgage payments, a refinance can help you switch to a more reliable fixed-rate mortgage. If mortgage rates are now low, changing to a fixed-rate mortgage can help you lock in a favorable mortgage rate and save you money on interest.
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Cons Of Refinancing Your Mortgage
Depending on your situation, refinancing might not be in your best interest. Let’s go through some of the disadvantages of refinancing a home loan.
Paying For Closing Costs
Refinancing is similar to taking out a mortgage for the first time in that you’re still expected to pay closing costs. These fees are usually between 2% – 6% of your new loan amount. For a $200,000 mortgage, for instance, you can expect to pay $6,000 – $12,000 in closing costs.
Fees covered in closing costs include the application fee, loan origination fee, home appraisal fees, homeowners insurance and lender fees. Evaluate whether the costs associated with closing on your new loan are worth the savings that come with a refinance. If the closing costs are a concern, ask your lender if they will consider rolling the closing costs into your loan, reducing your out-of-pocket expenses.
Increasing Your Monthly Payments
Another downside of refinancing is that you could end up increasing your monthly mortgage payments. If you refinance to a mortgage with a shorter repayment period, this could increase your monthly payments because you have less time to pay off your loan. The advantage of this option is that you’ll pay off your mortgage quicker. But if you can’t afford higher monthly mortgage payments, this won’t be the best refinance option for you.
Lengthening Your Loan Term
The downside of lowering your monthly mortgage payments is that it will increase the time necessary to pay off your new loan. Lengthening your loan term also means you’ll be paying more in interest over the life of the loan. Consider shortening your term, which increases your monthly payments, if you want to reduce how long it takes to pay off your mortgage. If you have strong credit, you can also consider searching for a new lender that offers a better interest rate on refinance loans.
Draining Your Home Equity
If you plan on using a cash-out refinance mortgage, you will end up using your equity to finance it, unlike other types of mortgage refinance loans. In a cash-out refinance, you borrow more than you need to pay off the original mortgage and keep the leftover funds. The cash you receive comes from your home’s equity. Lenders often allow borrowers to use only 80% of their home’s equity (sometimes 90%, but it isn’t common) in a cash-out refinance mortgage, so while you won’t completely drain your home equity, your stake in the home will be considerably less. The good news? As you pay down the new mortgage, your equity will likely increase over time.
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Weighing The Pros and Cons Of Refinancing A Home: Should You Refinance
Whether it’s a good idea to refinance your mortgage largely depends on your situation and your goals. You might also choose to refinance simply because mortgage rates are low and you’re likely to save money over the life of your loan.
Refinancing your mortgage is one way to stop having to pay PMI, if your new loan balance is less than 80% of the home’s value when you refinance. Similarly, if you qualify for a refinance loan, any co-signers or co-borrowers on the original mortgage can be removed.
No matter the circumstances, you’ll be in a better position to refinance if you have a good credit score and meet other lender requirements.
Refinancing isn’t for everyone. For instance, you might not want to refinance if rates are high or you are experiencing financial hardship and having trouble affording your monthly mortgage payments. If you plan to move shortly after using a cash-out refinance, you may end up with less money when you sell your home. In some cases, lenders will require a waiting period before you can refinance a mortgage, so if you recently purchased your home, it may be too soon to apply for one.
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The Bottom Line
Refinancing your mortgage may be a good option if you’re looking to change your term, take advantage of low interest rates or access the equity you’ve built in your home. You’ll have to cover the costs of refinancing, though, and you might not want to take on the new rate, term or monthly payment. Weigh the pros and cons of refinancing before deciding whether it’s right for you.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
