Costs and Benefits of Refinancing
There are many good reasons to refinance your home loan. Refinancing can lower your monthly payment or help you build equity faster. It can also allow you to drop your mortgage insurance or even get some extra cash for other uses.
However, refinancing isn’t a no-brainer. For one thing, whenever you refinance you must pay closing costs on your new home loan, which can easily add up to several thousand dollars. This may offset any savings you could get from a lower rate or a shorter loan term, so it’s important to consider when calculating your new payment.
So is it a good idea to refinance? That depends on your specific situation. There are several different types of home refinances, each with its own costs and benefits.
Refinancing to Lower Your Interest Rate
One of the most common reasons to refinance is to get a better interest rate on your loan. You can do this when overall interest rates have fallen or when your credit score has gone up, allowing you to qualify for better rates.
Benefits: A lower rate means a lower monthly payment, which frees up extra cash in your monthly budget. It also means you’ll pay less in interest over the life of the loan.
Costs: The amount you save in interest might not be enough to make up for the closing costs on your new loan.
When It’s a Good Idea: The old rule of thumb was that it’s usually worth refinancing if you can lower your interest rate by at least 2 percentage points. However, today it’s considered worth doing if you can lower your rate by just 1 percentage point. When comparing your old and new rates, make sure to look at the APR, which factors in various closing costs and fees.
Refinancing to a Shorter-Term Loan
If you’re currently in a 30-year mortgage, you can get out of debt quicker by refinancing it to a shorter term. All lenders offer 15-year loans, and some offer other choices as well.
Benefits: Shortening the term of your loan means you’ll build equity faster. Also, it usually gets you a lower interest rate, with all the benefits that brings.
Costs: With fewer years to pay off your loan, your monthly payment will likely be higher.
When It’s a Good Idea: If you can afford the new monthly payment, a shorter-term loan will save you money in the long run. In some cases – for instance, if interest rates have fallen, or if you’ve already paid down a big chunk of the mortgage principal – you can actually get a lower payment and a shorter loan term all in once, which is a real a win-win.
Refinancing to a Longer-Term Loan
You can also go the other way with your loan term, refinancing from a 15-year mortgage into 20-year or 30-year loan.
Benefits: You’ll lower your monthly payments, freeing up cash for other uses.
Costs: Besides taking longer to pay off, a longer-term loan usually comes with a higher interest rate. Overall, you’ll pay more over the life of the loan.
When It’s a Good Idea: Increasing your loan term can help you deal with a blow to your budget, such as a job loss or cut in pay. It’s most helpful when your new mortgage has no prepayment penalties. That way, if your cash flow situation improves later on, you can make extra payments to save on interest and shorten your payoff time.
Converting to a Fixed-Rate Loan
If you have an adjustable-rate mortgage (ARM), you can refinance into a fixed-rate loan.
Benefits: ARMs start out with a low initial interest rate. However, after the introductory period – usually three or five years – the rate starts to rise and fall based on national interest rates. If interest rates are on the rise, refinancing your ARM to a fixed-rate loan lets you lock in a low rate and keep your payment low.
Costs: If interest rates have already gone up, your new interest rate might still be higher than the introductory rate you had to start out with. Thus, your monthly payment could go up.
When It’s a Good Idea: Refinancing to a fixed-rate loan is a good idea if interest rates are continuing to rise. Even if your rate goes up, it will still be lower than what you’d pay after the introductory period.
Converting to an ARM
You can also do the opposite and convert your fixed-rate loan to an ARM.
Benefits: Switching to an ARM lets you take advantage of the low introductory rate for the next few years. It can also keep your payments low if interest rates continue to fall during that time.
Costs: There’s a risk that interest rates could rise rather than fall, resulting in a higher rate when your introductory period is up.
When It’s a Good Idea: If you’re planning to move in a few years, refinancing to an ARM has little risk. By the time your introductory rate expires, you’ll have sold the house and moved on.
Refinancing an FHA Loan to a Conventional Loan
If you bought your house with an FHA loan, you must make monthly insurance payments for the life of that loan. However, if your credit score is high enough (at least 620), you can finance to a conventional loan instead.
Benefits: You won’t need to keep paying insurance forever.
Costs: If you have less than 20 percent equity in your home, you’ll still have to pay private mortgage insurance. However, those payments go away once you reach 20 or 22 percent equity.
When It’s a Good Idea: If you have 20 percent equity in your home or you soon will.
Refinancing to Tap Home Equity
If you’re like most people, your home is your most valuable asset. However, the money tied up in your house is money you can’t spend. A cash-out refinance lets you turn your home equity into cash. You can do it if you have equity of at least 20 percent for conventional loans, or 15 percent for FHA loans.
Benefits: You can use the extra cash to pay off other debts, remodel your home, or put your kids through college.
Costs: It will take you longer to become debt-free.
When It’s a Good Idea: If you have other loans at higher interest rates than your mortgage, you’ll save money by tapping your home equity to pay them off. Remodeling is also a good use of home equity if it raises the value of your home, because you could actually end up with more equity than you started with.
Whatever your reason for refinancing, you need to balance the costs against the possible benefits. If you need help figuring that out, you can always get in touch with an Ethos Lending mortgage specialist who can help you figure out your best options.
Ethos Lending is a new type of mortgage lender. We use technology to keep our operational costs as low as possible. From closing costs to interest rates, we have made it our mission to make the process of buying a home more affordable. Get in touch with one of our mortgage specialists to learn more.