There are many reasons to refinance your mortgage. You can refinance to lower your mortgage rate, reduce your monthly payment, shorten the length of your loan, change your mortgage program or use your homeowner equity to take cash out or consolidate high cost debt. Refinancing usually comes at a cost plus it can take a lot of time so there are several factors to consider before moving forward.
When evaluating if you should refinance, you should weigh the financial benefits against closing costs to determine what makes sense financially. You want to make sure that you can recover any potential costs within a reasonable period of time otherwise it may not make sense for you to refinance. For example, if you refinance to consolidate debt, you should save money every month by cutting your total debt payments, including your mortgage. If your debt expenses do not go down, then you probably should not refinance.
Lowering your monthly loan payments is only one consideration, however, and may not be your determining factor. If you decide to refinance into a shorter term mortgage, such as going from a 30 year to a 15 year loan, your monthly payments may go up, but your mortgage rate should be lower plus you likely save a lot of money in total interest expense. Slicing your loan term in half can save you tens of thousands of dollars, depending on your loan amount and interest rate.
Another scenario when you may not see an decrease in your monthly payment is if you change mortgage programs when you refinance. For example, if refinance an interest only mortgage with a fixed rate loan, your monthly payment may actually increase in the short term because you start paying both principal and interest. Over the long run, however, the payment on a fixed rate mortgage may prove to be lower because the payment and interest rate on an interest only loan can change and potentially increase.
Paying a higher monthly mortgage payment in the near term may end up saving you a lot of money in the long run. So part of the decision making process depends on your time horizon and how your mortgage payment an interest rates may change in the future. This is also the reason why refinancing can be particularly beneficial in a rising interest rate environment. Changing your loan program and locking in the certainty of a fixed rate loan can provide peace of mind for borrowers.
People also choose to refinance for reasons that are completely beyond the numbers. For example, you may want to take cash out of your home to pay for a major home renovation or for college tuition. In this scenario, refinancing is less about lowering your mortgage rate or changing your loan program and more about accessing the equity in your home. You certainly want to pay the lowest rate and closing costs possible any time you finance, but with a cash-out refinance your priority is what you are going to do with the loan proceeds. In many cases your home may offer the least expensive financing option available, especially when you compare mortgage rates to the interest rate on a credit card, personal loan or home equity loan.
We highlight the top reasons to refinance your mortgage below and outline what you should know about each. The more you understand about why you should refinance, the more informed decision you can make to determine if it is the right option for you.
The most common reason to refinance your mortgage is to reduce your mortgage rate and monthly payment. You may be able to refinance at a lower rate because interest rates have dropped or if your credit score improved or you have more equity in your property as compared to when you initially obtained your mortgage. For example, you may have paid down credit card bills which caused your credit score to increase or completed a home renovation project which resulted in an increase in your property value and equity. A higher credit score and increased property equity may enable you to qualify for a lower interest rate.
Use our Mortgage Refinance Calculator to determine how much money you can save by lowering your rate
You may also be able to obtain a lower interest rate by refinancing into a different mortgage program. For example, the initial interest rate on an adjustable rate mortgage (ARM) is typically lower than the rate on a fixed rate mortgage.
As a general rule, if you are refinancing to reduce your interest rate then your new rate should be at least .75% lower than your existing rate to justify the refinance closing costs. Additionally, your new, lower monthly payment should enable you to recover your closing costs, or breakeven, within 30 months. You can divide your closing costs by your monthly mortgage payment savings to determine the breakeven point for a refinance.
The table below compare refinance rates and closing costs for leading lenders near you. Contact multiple lenders in the table to shop for your refinance.
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Reducing your mortgage term when you refinance enables you to reduce your interest rate and total interest expense over the life of your mortgage. For example, the interest rate on a 15 year mortgage is typically .5% - 1.0% less than the rate on a 30 year mortgage. A mortgage with a shorter term and lower interest rate results in significantly reduced total interest expense over the life of the mortgage. For example, a $250,000 15 year mortgage with a 2.750% interest rate saves a borrower approximately $100,000 in total interest expense over the life of the loan as compared to a 30 year mortgage with a 3.500% interest rate.
Review Refinance to Reduce Your Mortgage Term
The downside to a shorter mortgage term is that your monthly mortgage payment increases (even though your interest rate goes down). Reducing your mortgage term when you refinance may cost you a little more each month but can save you thousands of dollars in the long run.
Refinancing your mortgage also provides the opportunity to change your mortgage program. As mentioned above, borrowers can change from a fixed rate mortgage to an adjustable rate mortgage (ARM) to lower their interest rate. Additionally, borrowers with ARMs or interest only mortgages can refinance into a fixed rate mortgage to eliminate the risk that their interest rate and monthly payment will increase in the future.
Understand the benefits of Refinancing To Change Mortgage Programs
Although it can be difficult to predict interest rates, if you think rates will increase in the future refinancing an ARM or interest only mortgage into a fixed rate mortgage can save you thousands of dollars over the life of your loan. Plus a fixed rate mortgage offers the peace of mind that your interest rate and monthly payment will never change.
In a cash-out refinance your new mortgage amount is greater than the principal balance of your existing loan and you keep the difference, less any closing costs, when the refinance closes. For example, if your existing mortgage balance is $100,000, and you get a new $150,000 loan with $3,000 in closing costs then you take $47,000 in cash-out by refinancing. $150,000 (new mortgage balance) - $100,000 (existing mortgage balance) - $3,000 (closing costs) = $47,000 (cash out to borrower). You can use the proceeds from a cash-out refinance for a variety of purposes including to pay for a home renovation or college tuition.
Use our CASH OUT REFINANCE CALCULATOR to determine how much equity you can access by refinancing
Before pursuing a cash-out refinance borrowers should understand the approximate value of their property to determine if they have enough equity to pay off their existing mortgage and receive the proceeds they want by refinancing. For a cash-out refinance, lenders typically permit a maximum loan-to-value (LTV) ratio of 60% - 80%, depending on the amount of money the borrower is taking out. The lower LTV limits typically apply when borrowers are taking a significant amount of cash out (greater than ~$250,000).
Borrowers considering a cash-out refinance should also evaluate a home equity loan or line of credit (HELOC) to access the equity in the property.
With a debt consolidation refinance you use the proceeds from your new mortgage to pay off your existing loan as well as high cost debt, such as a credit card bill. Consolidating debt with a high interest rate should enable you to reduce your total monthly debt payments. For example, you may be able to use a new mortgage with a 5% interest rate to pay off credit card debt with a 18% interest rate. In an ideal scenario, with a debt consolidation refinance your new mortgage payment is less than your old mortgage payment plus your old debt payments, enabling you to save money every month.
Use our Debt Consolidation Refinance Calculator to understand if you should pay-off debt when you refinance
Borrower should also consider total interest expense when evaluating a debt consolidation refinance. In many cases it may not make long-term financial sense to replace short-term debt, such as a credit card you are going to pay-off within three-to-five years, with long-term debt such as a mortgage, even if the short-term debt has a higher interest rate.
You may be able to eliminate mortgage insurance such as PMI by refinancing, although eliminating PMI should not be your sole reason to refinance. Lenders typically require you to pay private mortgage insurance (PMI) if the loan-to-value (LTV) ratio when you obtained your mortgage was greater than 80%. LTV ratio is the ratio of your mortgage amount to the fair market value of your property. If you believe your LTV ratio declined to below 80% due an increase in property value or reduction in your mortgage balance then the PMI should be removed when you refinance.
Please note that with conventional loans, you do not need to refinance your mortgage to have PMI removed. You can submit a request directly to your lender to have the PMI removed without incurring the costs involved in a refinance. So unless you realize an additional benefit such as lowering your mortgage rate or reducing your loan term, it probably does not make sense to refinance if your only reason is to eliminate PMI.
Review What is PMI and Do I Need to Pay It?
If you have a government-backed loan such as an FHA or USDA mortgage, you are required to pay mortgage insurance premium over the entirety of the loan and you cannot request to have it removed regardless of your LTV ratio. In this scenario, refinancing to remove mortgage insurance makes more sense as long as your new interest rate is lower than the rate on your current loan plus the mortgage insurance.
"Determining Whether to Refinance." My Home by Freddie Mac. Freddie Mac, 2019. Web.