When you refinance a mortgage you pay off your existing mortgage loan and replace it with a new mortgage. Homeowners might want to refinance for several different reasons. Some of the most common reasons include obtaining a lower rate, shortening the mortgage loan term, converting from a fixed-rate mortgage to an adjustable-rate mortgage (or vice versa) and tapping into the home's equity to finance a major purchase or consolidate debt. Each case can involve benefits, but also poses pitfalls. Since refinancing can cost as much 1% and - just like taking an original mortgage - requires an application, title search, and appraisal fees, homeowners need to carefully analyze all of the factors involved before initiating the process to determine whether their refinancing is truly beneficial.
Again, some of the most common reasons for refinancing are:
1. To Obtain A Lower Interest Rate
Lowering the interest rate on an existing loan is one of the best reasons for refinancing a mortgage. The rule of thumb historically was that it was worth refinancing if your interest rate could be reduced by 2% at least. In the current low interest rate environment, many lenders have made the case that a savings of 1%, or even less, is enough of an incentive to refinance.
Reducing your rate helps you save money by lowering your monthly payment. For instance, a $100,000 home with a 30-year fixed rate mortgage that has a 3% interest rate will have a monthly payment of $421. With a 2% interest rate, the payment will be reduced to $369. If you want to simulate more payment scenarios use this mortgage calculator.
Alternatively, you could obtain a lower rate and get a mortgage that allows you to continue to pay the same payment each month ($421, in the above example) and to apply the difference between the interest you pay and the lower interest you could pay to lowering the total owed – i.e., amortizing the mortgage principal. This strategy would enable you to pay off your mortgage years earlier.
2. Shorten the Loan Term
Whenever interest rates go down, homeowners frequently have the chance to refinance their existing loans to a shorter term that enables a much quicker amortization and, hence, more home equity built. For the $100,000 home with a straight-line 3% 30-year fixed-rate mortgage that involves a monthly mortgage payment of $421, approximately $171 is attributable to paying down or amortizing the mortgage. If you were to refinance at 2% and shorten the term to 15 years, the monthly payment would go up to $643, but over $440 of that amount would be attributable to mortgage amortization in the first month (and that amount rises from there). You can play with your own numbers and extrapolate how shortening your term loan would accelerate amortization of your own mortgage with BestCashCow’s mortgage calculator.
If you have a fixed-rate mortgage in a rising interest rate environment, it will make much less sense to shorten the loan term in order to pay off your mortgage quickly. Instead, you would be better served by adding to your monthly mortgage payment or by making annual or semi-annual lump-sum payments in order to pay down the mortgage balance. Before making any excess payments, you should be sure that your mortgage lender permits your mortgage to be paid down without a penalty.
3. Convert Between An Adjustable-Rate Mortgage and Fixed-Rate Mortgage
Although an Adjustable-Rate Mortgage (ARM) will often start out with a lower rate compared to a fixed-rate mortgage, frequently periodic adjustment will result in increased rates making them higher than fixed-rate mortgages that are being offered. The impact can be costly in a rising rate environment, even though many ARMs have escalation clauses that limit the amount that the ARM can adjust upwards each year. Converting to a fixed rate mortgage can often both lower the interest rate and fix the interest rate for the longer term. It also eliminates the worry about interest rate increases in the future.
On the other hand, it can be financially beneficial to convert from a fixed-rate loan to an ARM when interest rates are falling. The ARM's periodic rate adjustments can result in lower interest rates and monthly mortgage payments that are smaller, eliminating the need to refinance in order to take advantage of lower interest rates each time they go down. Even in a stable or rising interest rate environment, it might also benefit homeowners who are not planning to stay in their home beyond the fixed period of the ARM loan to convert to an ARM, as the rate during the fixed period (usually 5 years) is often lower than that for a long-term fixed rate mortgage.
4. Consolidate Debt by Tapping Equity
Refinancing your home to consolidate your debt is the most common reason that homeowners refinance. It is often attractive to pay for major expenses, such as Obamacare premiums, college education and home remodeling costs, with the equity that you have built in your home. It is often not only a lower interest rate than the other types of loans that might be available, but because mortgage interest on your primary and secondary homes is usually tax deductible, it can be a solid tax planning strategy. But, while it may be a financially sound idea, the reality is that, especially if you are approaching retirement, it may not be wise to increase the length and/or amounts of your monthly mortgage payment.
Those who need or want to tap into their home equity for major expenses will often find that a home equity loan is a more attractive option, as it does not require the same amount of work or the same costs.