Why Homeowners Refinance
Refinancing your mortgage means replacing your current mortgage with a new loan. The most common reasons why owners refinance are to lower their interest rates and lower their monthly payments. However, homeowners may refinance for a variety of reasons, such as wanting to change the terms of the loan, using their home’s equity to make large purchases, paying off the loan more quickly, and more.
Refinancing works similarly to obtaining a home mortgage and involves many of the same documents, an application process, and doing your due diligence to find the right loan option for you. You’ll need to meet the lender’s requirements to qualify for a loan and go through underwriting and closing, the same as you did when you took out your home’s first mortgage.
Homeowners typically don’t refinance until they’re a few years into their current loan and have built up equity in their home. When interest rates are lower than what you’re currently paying, that’s a good time to consider refinancing. The generally accepted rule of thumb is that it’s okay to refinance if you can lower your interest rate by about 1 percent, but this rule of thumb may vary greatly. Factors such as loan amount and remaining term must be considered when calculating potential savings. The refinance rate fluctuates because of the market, and your final rate will be impacted by your credit score, your debt-to-income ratio, and home equity.
Sometimes it can take a few years to hit a “break-even point,” where you start to see savings after the upfront costs of refinancing. If you’re intending to sell soon, refinancing may not be the best option.
Here are the potential benefits and reasons why you may consider refinancing your home.
Reduce Your Interest Rate
This is a common reason why homeowners try to refinance and is typically a smart move. Lowering your interest rate could potentially save you hundreds of dollars a year. However, there is an upfront cost to refinancing. Closing costs and fees should be factored into the decision to refinance.
In addition, you should take into account the money you’ll be spending over the long run if you extend the terms of your loan. For example, if you’ve been making payments on a 30-year loan for five years, and then refinance to a lower interest rate with a new 30-year loan, you’re going to have an extra five years of payments. That doesn’t mean the refinance isn’t worth it, but it is something to keep in mind.
Lower Your Monthly Payment
Refinancing can significantly reduce your monthly payments, depending on your terms. These savings add up and can allow you to pay off other debts, build up your savings, or apply that extra money to the mortgage itself in order to pay off the loan sooner.
Pay Off Your Mortgage Faster
While a 30-year mortgage made sense as a first-time homeowner early in your career, you may now be in a stronger spot financially and able to pay more. Refinancing can cut years off your loan and potentially save thousands of dollars in interest over the life of the loan. Shorter term loans also typically carry lower interest than longer ones.
For example, if your mortgage has 20 years left on it and you refinance into a 15-year mortgage with a fixed rate, you’re paying off your loan five years faster. And since it’ll likely be a lower interest rate since it’s a shorter term, you may not even see much of a change in your monthly payments.
Change Mortgage Types
You may want to switch from an adjustable-rate mortgage (ARM) to a fixed-rate one. An ARM typically offers a lower interest rate for a set period of time, and then can reset after that to a higher (or lower) rate, whereas a fixed-rate loan will stay stable and predictable. ARMs work well for homeowners who don’t plan to own their home for more than a few years because they can capitalize on the lower interest rate in the beginning and then sell before those rates climb.
For homeowners who want to stay in their home for as long as possible, switching from an ARM to a fixed-rate mortgage can offer peace of mind for the rest of the term of their loan.
Eliminate Private Mortgage Insurance (PMI)
PMI is typically required of homeowners who purchase a home with a low down payment or no down payment at all. Because the homeowner is at a higher risk of defaulting on their loan, this type of insurance makes lenders feel more comfortable about loaning to them.
As time goes on and the value of the home increases while the balance of the loan decreases, homeowners may be able to ditch their PMI by refinancing and, in turn, reduce their monthly payments. It’s up to the lender to decide when it’s okay to remove the PMI, however.
Even if PMI can be cancelled without refinancing, homeowners who obtained a loan through the Federal Housing Administration (FHA) have an insurance premium that they will continue to pay until the home is sold or refinanced.
Use Home Equity To Borrow Cash
Equity is essentially what you “own” of your home, or the difference between what you owe and what it’s worth. Most homes increase in value over time, even more so if you upgrade aspects of the home while living there.
A cash-out refinance will allow you to refinance for a higher overall amount rather than what you currently owe. That way you are able to take the extra money out as a cash payment. You can use this to pay off outstanding debts with high interest rates, consolidate your debts, make home improvements, or make a large purchase like a car. However, this option can be risky, as you’re not reducing your overall debt or building up your equity, both of which are goals that most homeowners should have.
Should You Refinance?
Refinancing can be a savvy financial move if it reduces your overall costs, shortens the terms of your loan, or helps build equity. Be sure to keep in mind how long you plan to stay in the home, and remember that it may take years to hit your “break-even point,” where you can recoup the upfront cost of refinancing and actually see those savings roll in.
Learn more in our Life Guide Center about Refinancing Your Home
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