Whether you’re securing a lower interest rate, tapping into home equity or changing up your terms to be mortgage-free faster, sometimes it makes sense for homeowners to refinance their home loan.
When you refinance your mortgage, you’re replacing your current home loan with a brand new loan, with new interest rates, terms, and potentially even a new lender. You’ll need to go through the application and closing process again, with your lender reviewing your finances, appraising the property and organizing new terms for repayment for your refinanced loan.
Refinancing is common territory in the United States. Refinancing totaled $2.8 trillion in 2022, according to 2022 industry data. All in, borrowers saved $2,700 in mortgage payments by refinancing and locking in rates that were on average 1.15 percent lower than their initial mortgage.
Here’s a look at the popular reasons why homeowners may decide to refinance their mortgages.
Reducing your interest rate
If interest rates have dropped, you may opt to shop around to secure a lower rate on your loan, saving you a significant amount of money over the lifetime of your mortgage. This is the one of the best reasons to refinance your mortgage.
But because refinancing is expensive with a hefty list of closing costs you must pay for, you should refinance if you can secure an interest rate that’s about one percent to two percent lower than your current mortgage.
When you secure a lower interest rate, you’re also ensuring you’re spending less of your monthly payments on interest and applying more towards your home equity. The move can also decrease your monthly mortgage payments, giving your budget a bit more breathing room.
If your credit score has improved since you applied for your first mortgage, you could also look into refinancing. You may have paid down debts like your credit card and line of credit, stayed on top of payments for a long period of time, or had a boost in savings, making you a better candidate for a lower interest rate.
Shortening your terms
You may have a higher income, meaning you have more cash flow to put towards your mortgage. With this in mind, some homeowners may choose to refinance their loan, changing from a 30-year term to a 15-year term.
This move could see your mortgage payments going up because you’re paying off your loan in half the time, but you’ll be mortgage-free faster. Your lender may provide you with a lower interest rate, to boot.
And if the market dictates lower interest rates on its own, you may find your payments will be lower, even with a shortened term. Halving a 30-year fixed-rate mortgage on a $100,000 home, for example, from 9 percent to 5.5 percent interest could see only a slight change in monthly payments from $805 to $817. If your interest rate stays the same, you’ll end up paying higher monthly payments.
It’s worth noting, even if your interest rate isn’t lowered, if you can shoulder higher mortgage payments and pay off your loan faster, you’ll save significantly on interest over the lifetime of your loan.
Lengthening your terms
On the other hand, you may look into refinancing your loan to extend the terms and lower your monthly payments.
You could have started with a 15-year mortgage but are having trouble keeping up with the monthly payments. Refinancing to a 30-year loan can ease the financial pressure, giving yourself twice as long to pay off your property.
Locking in a fixed interest rate
If you started your initial home loan with an adjustable rate mortgage, you may decide to refinance to lock in a fixed interest rate instead.
Adjustable rate mortgages usually come with a lower starting interest rate, but they could creep up costing you hundreds of dollars more in interest on your monthly payments. For homeowners who prefer a predictable monthly mortgage payment to budget for, locking in a fixed rate mortgage is your better bet.
Once you refinance to a fixed interest rate, you’re guaranteed the same rate for the lifetime of your repayment period. This way, you don’t have to worry about rising interest rates tampering with your monthly payments.
Tapping into home equity
Whether you need money for home renovations, to pay off debt or for other big ticket items, you may be looking into a cash-out refinance, making use of the home equity you’ve established.
In a nutshell, a cash-out refinance replaces your existing mortgage with a brand new one, with a new loan amount, interest rate, terms and monthly payment. Your refinance will leave you with a larger balance than your existing mortgage, giving an extra lump sum of cash.
Essentially, you’re turning a portion of the home equity you’ve built up over the years into a cash payout. As a rule of thumb, lenders allow homeowners to borrow up to 80 percent of their home’s market value.
It’s worth checking on whether a home equity loan or home equity line of credit is better suited for your needs. Cash-out refinancing tends to be the most expensive option.
When is it not worth it to refinance?
While refinancing your mortgage can save you cash, help you tap into home equity, or change up your loan terms to accommodate your needs, do some number crunching before proceeding.
This is because refinancing your mortgage comes at a cost, to the tune of about $2,375, according to 2022 data from ClosingCorp. You should earmark about two percent to six percent of your loan principal in closing costs for refinancing your loan, according to industry estimates. That means if your refinanced mortgage is about $200,000, you could be spending between $4,000 to $10,000 in closing costs.
If you won’t reap any savings from a lower interest rate or changed terms after you’ve accounted for closing costs, it may not be financially wise to go ahead with refinancing your loan. Say, for example, you’ve spent $4,000 on refinancing your loan only to lower monthly payments by $100, it could take you 40 months until you break even.
If you’re staying put over the next decade or two as you chip away at your mortgage, the closing costs for refinancing your loan are a justifiable expense. But if you plan on moving within the next few years, you’ll have spent time, effort and your hard-earned cash for no reason.
If your credit isn’t in great shape or the market isn’t offering competitive interest rates, you should also to wait until you can secure a lower interest rate too. Remember, you’re aiming to lower your interest rate by at least one to two percent.
Despite the upfront costs, refinancing can be a great financial move for homeowners if it helps you the interest you’re paying, shortens your terms, or helps you build equity faster.
Your job before taking the plunge and refinancing your mortgage is to do your homework to make sure it’s worth the expense. Shop around to see what interest rates lenders are offering, test out mortgage calculators, and consider how long you plan on living in your home. These steps will help you uncover how much you may be saving in the long haul by refinancing.
Carmen Chai is an award-winning Canadian journalist who has lived and reported from major cities such as Vancouver, Toronto, London and Paris. For NewHomeSource, Carmen covers a variety of topics, including insurance, mortgages, and more.