With interest rates at a historic low, many Americans are considering refinancing their mortgage. You might have gotten calls or letters from lenders encouraging you to make the leap. But refinancing is a decision that involves large sums of money and your beloved home. You might be reluctant to jump in without knowing more.
What is Refinancing?
Refinancing essentially means that you take out a new mortgage and use it to pay off your old mortgage. This generally will not reduce your total debt load and could in fact increase it. For example, you might roll closing costs into your new loan. Or you might do a “cash back refinance” in which you reduce your equity in the home in exchange for a lump sum you might use for renovations or whatever else you desire. That can increase the total amount you owe.
You will still be required to use the property as collateral in the loan. Refinancing won’t eliminate the risk of your home being foreclosed on if you don’t make timely payments on the mortgage.
Should You Refinance?
There’s no one right answer to whether or not refinancing is the best choice for your particular situation. You’ll need to consider factors such as how much equity you have in your home, how your credit score has changed since you originally got the loan, and how long you plan to stay in your current house. Also keep in mind that closing costs generally add up to between 2% and 6% of the loan amount, so you will need to figure that into your savings calculations.
Potential advantages of refinancing your mortgage include:
- Lower monthly payments due to a lower interest rate—especially if your credit score has improved since you got the original loan.
- A shorter loan term—e.g. if you refinance from a 30-year to a 15-year mortgage—which means you pay less interest overall.
- You could get a mortgage with more favorable terms, such as switching from an adjustable- to a fixed-rate mortgage or eliminating PMI.
- A cash-out refi could allow you to improve the value of your property through renovations or pay off other debts, consolidating everything into one low-interest loan with a single monthly payment.
However, there are also several potential disadvantages to consider:
- You might not stay in your house long enough to recoup closing costs.
- Lowering your monthly payment could lead to paying more interest over time.
- On the other hand, saving in the long term could lead to higher payments in the short term, which could put a strain on your budget.
- Many people who refinance to consolidate debt don’t change their spending habits and find themselves with even more debt down the line—plus a higher mortgage payment!
Obviously not every item on this list will apply to your situation, but it’s important to consider every variable rather than simply jumping on a lower interest rate.
Cash-Out Refinance vs. Home Equity Loan
If you’re considering a cash-out refinance, you might wonder whether it would be better to get a home equity loan. They are similar in many ways. Both require you to have a certain amount of equity in your home. Both give you money that you can use however you see fit. (Of course, it’s wise to stick to using this money for things like improvements on your home rather than blowing it on luxury purchases!) Both types of loan use your house as collateral and therefore failure to make payments on time can lead to foreclosure.
There are some key differences, however. When you take out a home equity loan, it’s essentially a second mortgage, whereas a refinance just changes the terms of the first mortgage. If you have a home equity loan, default, and your house goes into foreclosure, the lender who owns your mortgage will have first dibs on the proceeds. The lender who owns your home equity loan will come second. This makes home equity loans somewhat higher risk for lenders, so it’s harder to qualify for one and interest rates will generally be higher.
On the other hand, home equity loans have significantly lower closing costs than a cash-out refinance. If you plan to sell your house before you hit the break-even point on a refinance, a home equity loan might actually save you money.
You should also consider whether interest rates are low enough to justify the cost of a refinance. Maybe they haven’t changed much since you originally purchased your home. Maybe your credit score has taken a bit of a hit so you don’t qualify for the rock-bottom prices anymore. In that case it might be worthwhile to see if you qualify for a home equity loan while keeping your first mortgage at its current low rate.
How to Decide What’s Right for You
Taking out a new loan on your home is a big decision. All the options could seem a bit intimidating. If you’re considering refinancing, get quotes from more than one bank and compare your choices carefully before you decide. You can also contact us to connect with an experienced financial advisor.