Mortgage interest rates continue to be at one of the lowest levels in recent history. This raises the question for many homeowners: should you refinance your mortgage? As you weigh the pros and cons of refinancing, there are many things to consider. Some homeowners refinance to lower their monthly mortgage payments by reducing their interest rates. Others hope to increase the pace at which they are paying off their mortgage principal by lowering the interest component. There are a number of good reasons why you should consider refinancing your mortgage but also some drawbacks.
Before you reach out to a mortgage lender to explore refinancing options, you should first understand the various pros and cons of refinancing a mortgage. This article will explore this while also providing some background information on mortgage refinancing.
What is mortgage refinancing?
Refinancing a mortgage refers to the process of taking out a new mortgage loan to replace your existing mortgage loan. Homeowners typically refinance to take advantage of lower interest rates or increased home prices. Most of the time the new mortgage loan will have a lower interest rate than the existing mortgage loan.
Lets walk through an example. In the chart above, starting with mortgage A, a homeowner has a $250,000 home with $50,000 of equity and a $200,000 mortgage. The mortgage has a 30 year term and 4.5% interest rate. Therefore, this works out to a monthly payment of $1,013. In mortgage B, this same homeowner refinances his mortgage loan with a new loan that carries a 3.5% interest rate. You can think of this as replacing the $200,000 mortgage A with a $200,000 mortgage B. Because of the lower interest rate, this homeowners monthly payment falls to $898! This is the main reason why homeowners refinance the mortgage.
What about cash-out refinancing?
Using the same assumptions, we’ll explain how cash-out refinancing works. Again the example starts with mortgage A, a homeowner with a $200,000 mortgage paying a 4.5% interest rate and $50,000 of equity. With mortgage C, the homeowner replaces his $200,000 mortgage A with a $225,000 mortgage C that pays 3.5% interest rate. Because the homeowner is taking out a new mortgage that exceeds the value of his old mortgage, they are cashing out value from their property. In this example they are cashing out $25,000. So while their equity drops by this amount, because of the lower interest rate, their monthly payment is unchanged.
While it is common for homeowners to refinance their mortgage loans with their current lender, it is possible to change lenders when doing a mortgage refinance. Refinancing your mortgage may be an excellent idea if over time your credit situation has improved. For example if your credit score or debt-to-income ratio has improved, you could get offered a more attractive rate by lenders. Similarly, if interest rates have fallen since you closed on your original mortgage loan, refinancing could make sense.
Now that you’ve familiarized yourself with the concept of refinancing, lets go over some of the pros and cons of refinancing.
Pros of Refinancing
There are several benefits with refinancing your mortgage. As noted earlier, the overarching reason homeowners refinance is to get more favorable financial terms. Here are some of the advantages that come with refinancing your mortgage loan.
Switch from variable to fixed-rate rate mortgage
For homeowners that have adjustable-rate mortgages they face a lot of uncertainty. Adjustable-rate mortgages have fixed rates for a period of time before the rates adjust to higher levels. When the rates adjust, it is typically based on a spread above a reference rate. As a result, this creates a lot of uncertainty because if the reference rate increases the mortgage holder’s monthly payments will increase. By refinancing to a fixed-rate mortgage, you can eliminate this uncertainty. With a fixed-rate mortgage borrowers know exactly what their mortgage payments will be over the loan term. In a nutshell, refinancing your mortgage from an adjustable-rate to a fixed rate makes your interest payments substantially more predictable.
Lower the interest rate on your mortgage
This is by far the main reason why borrowers decide to refinance. Interest rates are continuously changing and move up and down depending on the economic cycle. The decision to refinance is often a result of borrowers taking advantage of falling rates. For example, if your mortgage was issued during a period where interest rates were high and they have since fallen you may want to consider refinancing. Monitoring news on mortgage rates nationally is something all homeowners should do.
Get rid of private mortgage insurance
If you bought a home and opted for a conventional mortgage loan but paid less than 20% as a down payment, you would need private mortgage insurance. Private mortgage insurance costs between 0.4% and 1% of the mortgage loan value according to research from Freddie Mac. Therefore on a $200,000 mortgage, private mortgage insurance could cost $720 to as much as $1,700 a year! Refinancing your conventional mortgage loan assuming you’ve now built equity could enable you to stop paying mortgage insurance. On the other hand, if you’ve got an FHA loan, the only way to cancel the mortgage insurance premium is by refinancing into a conventional mortgage once you hit 20% equity in the home.
Access cash for discretionary purposes
As outlined earlier on, a cash-out refinance is an attractive option for homeowners looking to raise money. In essence with a cash-out refinance you are borrowing against the equity in your home. Homeowners tend to choose cash-out refinance for a variety of reasons. It could be to access cash to pay off more expensive debt like credit cards and student loans. Often times homeowners use the funds to pay for home improvement projects.
Cash-out refinancing works by replacing the outstanding balance on your mortgage with a new mortgage that’s greater than your existing mortgage. The homeowner is “cash-out” the difference.
Extend mortgage term to provide financial flexibility
Another benefit of refinancing is that it allows you to refinance to a mortgage with a different loan term. The loan term can be shorter or longer but generally homeowners are looking to increase their loan terms. In the example shown in the chart above, the homeowner refinances their existing loan (Mortgage D) with a new loan (Mortgage E). Mortgage E has a 30 year term compared with Mortgage D’s 20 year term. Therefore the homeowner’s monthly mortgage payment falls by more than 20% from $1,160 to $898. This allows the homeowner some breathing room and allows them to be able to save more.
Cons of Refinancing
While there are several positives to refinancing, there are some drawbacks and other considerations.
Cash-Out Refinancing Reduces the Equity in Your Home
While a cash-out refinance allows you to borrow against the equity in your home, it also directly leads to a reduction in your equity. Like in the earlier example, equity in the home is reduced from $50,000 to $25,000 as a result of the refinancing. The reason why this is a risk is because if the value of your home declines you could end up with minimal to no equity. This is particularly problematic if you plan to sell the home in short order.
You Have To Pay Closing Costs, Again
Refinancing your mortgage involves taking out a new mortgage. Therefore you essentially repeat the original process and as part of it, have to pay closing costs again. Typically, closing costs include things like appraisal fees, lenders or origination fees, and other expenses associated with processing your mortgage. Generally these fees can cost between 3% to 6% of your loan amount, which is a considerable sum of money. So it is important to consider this when looking at how much you could save from lower interest rates. For example, if you could save $2,000 from lower interest costs from a refinancing, but will have to pay $3,000 in closing costs, that’s perhaps not a good idea.
Increases Your Monthly Payment
Refinancing your mortgage into a shorter-term loan can help you pay off your mortgage faster. However, it also increases the monthly mortgage payments. This is because you’re reducing the amount of time you have to repay the loan. For example, lets say you have a 30-year mortgage for $200,000 with a 4% interest rate. Currently, your monthly payment is $955 per month. But if you refinance to a 15-year mortgage for $200,000 with the same interest rate, you may have to make a monthly payment of $1,479.
While refinancing your mortgage can help you pay off your mortgage early, it is not usually a great option. This is because if your goal is to repay your mortgage loan more quickly, you can just make additional payments each month. By refinancing your mortgage to shorten the loan term, you incur closing costs and lower your financial flexibility.
You Could Incur Prepayment Penalties
Some mortgage loans have embedded in their agreements penalties for early repayment of the loan. The reason lenders add this provision is because their preference is for borrowers to pay back their mortgage loans more slowly. By paying back their loans more slowly, the lenders collect more interest payments. Review your loan documents to check for prepayment penalties. Depending on whether you have the penalties and the size of the penalty it could offset some or all of the benefits of refinancing.
Your Credit Score Has Deteriorated
As we noted earlier, when applying to refinance your mortgage, lenders will again pull your credit report and credit history. They’re doing to get a sense of your latest creditworthiness. Therefore if your credit score has worsened since your first mortgage you could end up with offers for your next mortgage that are less favorable. This clearly would defeat a lot of the purpose of refinancing your exiting mortgage.
Does Refinancing Hurt Your Credit Score?
If you’re like every other homeowner, you most definitely understand the importance of having a great credit score. And if you’re thinking of refinancing your mortgage into a new one, you may be wondering what impact refinancing may have on your credit. When it comes to mortgage refinancing, the effect on your credit score is usually quite minimal but it will likely have a short-term negative impact. Some points to consider:
- When you apply to refinance your mortgage, it is common for lenders or banks to make a hard inquiry on your credit report and history. A hard credit inquiry will likely hurt your credit score especially if you’ve had a few inquiries in a short period of time
- Refinancing your old mortgage into a new one will cause you to lose the credit history of your existing mortgage which will have some impact on your credit score
- A cash-out refinance could hurt your credit score since it involves increasing your total debt
Overall though, while a mortgage refinancing may have short-term effects on your credit score, it isn’t something to worry about. Declines in your credit score caused by mortgage refinance activities typically reverse quickly if you make regular and on-time payments.
There are certainly a lot of pros and cons to refinancing, and whether it makes sense for you comes down to your specific situation. By thinking through the various pros and cons we think you’ll at least make a more informed decision and avoid some of the mistakes homeowners tend to make.