How to Weight the Potential Pros and Cons of Refinancing a Mortgage

How to Weight the Potential Pros and Cons of Refinancing a Mortgage

One of the effects of the pandemic was a global reduction in interest rates. Because of this, many homeowners have considered refinancing their mortgages. A lower interest rate on your mortgage can benefit you in many ways, from lowering your monthly payment to reducing the amount of time you need to pay. However, the decision to refinance also comes with some important caveats and points you need to consider. Ultimately, the decision to refinance is just as critical as your initial choice to buy a home, since you are getting an entirely new loan. Before refinancing, it is important to do due diligence and ensure the decision makes sense in both the short and long term.

The Potential Benefits of Refinancing Your Mortgage

Refinancing can make sense in many situations. The major reason people refinance a mortgage is to reduce their monthly payment. If you can secure a significantly lower interest rate, you will end up paying less interest over the life of your loan and your monthly payment should decrease, as long as you maintain the same mortgage term.

Refinancing can give you more room in your monthly budget and can help you achieve other financial goals if money is tight.

Importantly, refinancing can also stabilize your interest rate if you have an adjustable-rate mortgage. While the interest rate for such a mortgage is likely currently quite low, it could increase significantly in the months and years to come. Switching to a fixed-rate mortgage can lock you into a lower rate to make your monthly payments predictable.

In some cases, refinancing your mortgage can help you repay the loan early. For example, if you have a 30-year loan, you may be able to refinance into a 15-year loan that does not have a significantly higher monthly payment. Doing this also saves on the amount of interest you end up paying for the life of the mortgage.

The other point to consider is the ability to get cash when you refinance. If you have significant equity in your home, you can often get some additional cash when you refinance by signing a new loan that is more than what you actually owe. This cash can be used to pay down other debt, cover educational expenses, or even launch a business. Many people choose to use this money to complete home improvements, which will increase the overall value of the home. You may be able to deduct some costs in this case as well.

The Downsides of Refinancing You Should Consider

Of course, refinancing is not the right choice for everyone. It can be difficult to get a new loan, and you could end up with a mortgage with less favorable terms than you have now. The primary downside to refinancing is that your mortgage clock will reset. If you refinance for 30 years, you start back at year zero and will end up requiring more time to pay off the loan, though your monthly payment is reduced. For many people, it only makes sense to refinance from a 30-year to a 15-year mortgage, so they aren’t left paying a mortgage into their retirement years. However, refinancing to a 15-year mortgage could mean paying more per month even if the interest rate is low, because the time frame is compressed. A higher payment can put additional stress on your budget. Before refinancing, make sure you understand how your monthly payment will change and when your new pay-off date will be.

You should also consider the costs involved in refinancing. The process typically involves closing costs that range between 3 to 6 percent of the mortgage total. In addition, you will pay fees for applications, loan origination, appraisal, and more. Sometimes, the savings from a lower interest rate do not outweigh these additional costs by much, which makes the option much less appealing. Always do the math to make sure it still makes sense to refinance even with these expenses. In addition, you could end up hurting your home’s value. For example, you will likely need to get a reappraisal when you refinance. If the housing market isn’t doing well, the value of your home could be less than it was before, and you may not have enough equity to complete the refinance.

Finally, it is worth mentioning that lenders have different requirements when it comes to refinancing, but you will need good credit to qualify for the lowest mortgage rates. In general, credit scores of 670 or above are considered good. However, banks may adopt more stringent criteria when rates are low.

The Bottom Line

The prospect of refinancing can sometimes sound like a better deal than it ends up being. That said, refinancing really can help some people reduce their monthly payments and even pay off their home sooner than expected, and with less interest. The bottom line is that you need to do due diligence and carefully weigh the pros and cons as you consider a refinance. By crunching the numbers, you can see exactly how much you might end up saving—or how much your costs might increase—and anticipate any compromises you may need to make along the way. Ultimately, the choice is yours.