When interest rates drop as they have in early 2020, many homeowners consider refinancing their mortgage. But low rates aren’t the only consideration for this important part of your personal finance management. You must also factor in your long-term financial goals, how long you plan to stay in your current home, your credit score, and more.
Why refinance?
People choose to refinance their mortgages for a variety of reasons. Some common reasons include obtaining a lower interest rate (and therefore lower monthly payments), shortening the duration of their mortgage, converting from an adjustable-rate mortgage to a fixed-rate mortgage (or vice-versa), or to raise funds to finance a purchase or emergency expense. So when might each of these reasons be right for you?
Refinancing for Lower Rates
First, it’s important to understand how mortgage rates work. They’re different from short-term interest rates set by the Fed. Mortgage rates are constantly changing, and don’t always mirror short-term rates. The rate you’re quoted on any given day could be higher or lower than what’s being advertised. That’s because your rate is primarily based on your credit score and the equity you have in your home.
With that said, refinancing to reduce the rate of your mortgage can provide huge long-term savings. If you can get a rate decrease of even a percentage point or two, it can have a noticeable impact on your monthly payments. It doesn’t take a math whiz to see the difference that can make over a 30-year term! Be careful, though – depending on your financial goals and situation, it may not be the right move.
There are significant costs associated with refinancing. For starters, it typically costs 2-5% of principal to refinance a mortgage. In addition, refinancing requires an appraisal, title search, and application fees. Add it all up, and you should be prepared to pay 3-6% of your principal during the refinancing process. It can take years to recoup the cost, so it’s usually unwise to refinance if you don’t plan to stay in the home for more than a few years. Try calculating how long it will take for the monthly savings from your refinancing to pay for the closing costs. If you plan to sell the house before then, it’s probably not a good idea.
Refinancing for Shorter Duration
In addition to refinancing to lower your monthly payment, you can refinance to shorten the loan’s term. When rates fall, you can opt to refinance with a shorter term-loan, meaning you’ll end up paying significantly less in interest. Depending on the rates, you may be able to do this without a significant increase in monthly payments. In other situations, you may decide higher monthly payments are worth it for the overall savings in the long run.
Adjustable-rate versus fixed-rate
Adjustable-rate mortgages (or ARMs) usually start out with lower rates than fixed-rate mortgages, but that can change with periodic adjustments. If rates have gone up over time, refinancing to switch to a fixed-rate mortgage can lower your rate and ensure future hikes won’t impact your loan.
If rates are falling, refinancing to switch to an adjustable-rate mortgage could be effective – especially if you don’t plan to stay in the home for long. You can take advantage of the lower starting rate of an ARM without having to worry about where rates will be in 20-30 years.
Cash-out refinance
A cash-out refinance allows you to borrow more than you owe on your home. You can use the excess cash to finance a purchase, such as home renovations or an emergency expense. Some people use this strategy to pay down other, higher-interest forms of debt, such as credit card debt. While it’s a good idea to replace high-interest debt with other, lower-interest debt, refinancing in this way often leaves borrowers in more debt than they started. For example, if the spending habits that brought about the credit card debt to begin with come back (as habits often do), you’re now out the refinancing fees, lost equity in your home, added mortgage payments across additional years, as well as the return of high-interest debt.