For most individuals, purchasing a house will be the largest financial transaction they ever conduct. How your current mortgage fits into your personal finances, and whether it makes sense to refinance, can have major impacts on your lifestyle. So, how can you know if it makes sense to refinance your mortgage?
There are a number of considerations to take into account when making this decision. At the end of the the day, it is important to understand both your motivation and the repercussions on your bottom line.
What Does it Mean to Refinance a Mortgage?
Refinancing a mortgage means that you will use either your existing lender or find a new one to purchase your old loan, and provide you with a new one.
The macro-environment is generally the trigger that causes individuals to consider refinancing, specifically when interest rates are lowered. The Federal Reserve Board of Governors, the central bank of the United States, is responsible for setting the Federal funds rate (also known as the Fed rate). This is the amount of interest banks must pay each other to borrow money overnight, and it directly influences the interest rates banks charge their customers to take loans.
Refinancing gives you a new mortgage that you will be responsible for paying, going forward. While a refinance can lead to better terms and a cheaper overall loan, changing mortgages (even with the same provider) does not come for free.
There are closing costs and other expenses that you will be on the hook for, though some providers might agree to waive some of these fees. You should be prepared to pay between 2-6% of the cost of the loan when you refinance, so this should figure into your calculations when making your decision.
Is it Good Idea to Refinance a Mortgage?
The answer, of course, like most personal finance-related queries, is that it depends on your financial situation and the overall market environment.
The following can be compelling reasons to refinance your loan:
(1) You can get cheaper financing: If interest rates are dropping, and you can get cheaper financing, it could make sense to refinance. This goes beyond your monthly payments, and should also include the overall cost of the loan (and the refinancing fees you are paying). You are probably already aware of how much you are paying on a monthly basis, but you should confirm how many more years it will take for your mortgage to be paid off if you continue making monthly payments at the current rate.
Using TipRanks’ mortgage calculator will help you to compare the cost of your current mortgage with the new one that you would be acquiring.
(2) You want to pay off your mortgage faster: Changing from a 30-year mortgage to a 15-year mortgage will allow you to pay off your mortgage more quickly. It will likely also raise your monthly payments, though if the interest rates have dropped enough the impact on your monthly budget might not be so dramatic.
(3) You want to change the type of mortgage: Mortgages vary based on both length and interest rates, but they have other defining features as well. For instance, there are fixed-rate mortgages, which stay the same throughout the life of the mortgage, and adjustable-rate mortgages (also known as ARMs), which fluctuate over time. These ARM tend to start with low interests rates but could jump up later, so refinancing before a potential rate hike could be in your favor.
In addition, certain mortgages, such as those that are guaranteed by the FHA, require mortgage insurance in addition to your principal and interest payments. The mortgage insurance is required for at least 11 years (though it could also extend through the entire life of the loan), so refinancing can be a way to get rid of these extra costs as well.
(4) You want to cash out your equity: As you pay your mortgage every month, you will gradually build up the equity in your house. In some situations, you might require an infusion of cash for another financial need. Refinancing will allow you to effectively sell some of the equity you have earned, in exchange for a sum of cash and a greater loan obligation that you will pay off in the years ahead.
Does Refinancing Make Sense For You?
Whether it makes sense for you to refinance will depend on your motivation, your situation, and the macro-environment.
In the most straightforward case, if interest rates are dropping and your credit score is in good standing, you could be well positioned to secure cheaper financing that will allow you to pay off your loan for less.
You could also potentially sign up for a quicker repayment scheme, which would also save you money in the long run (though your monthly payments might increase).
Changing the contours of your mortgage plan could also work in your financial favor, especially if you possess an ARM that is scheduled to increase.
In these scenarios, running the numbers between your current and future mortgages should give you a good sense for whether the hassle and costs are worthwhile. You should also take your coming plans into account. For instance, if you are looking to sell your house and move to greener pastures in the next few years, it is probably not worthwhile to refinance.
Taking money out of your mortgage is a trickier question to answer, as there might be a better way for you to access the needed funds without decreasing the amount of house you own.
If you do elect to proceed down this path, you will want to make sure to keep a sufficient amount of equity in your house. Going below 20% is probably not a good idea, as private mortgage insurance is required for homeowners who drop below this threshold.
Conclusion: Refinancing Your Life
Refinancing your mortgage is a big decision, one that should not be taken lightly. Your home is more than an asset; it is the center of your life.
As you think about reorganizing your obligations, keep both the monthly payments and the overall cost of the loan at the forefront. Like any financial decision, balancing your short-term obligations with your long-term finances remains paramount.
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