After you’ve owned a home for a while, you may start wondering if there’s a way to make your monthly payments lower, decrease your interest rate or otherwise improve your mortgage situation. Refinancing a mortgage means taking out a new loan and paying back the original loan. You would choose to go this route if the new loan had more favorable terms and expenses.
How it Works
When you refinance, you must go through a similar process as you did for obtaining your original mortgage, though likely with stricter qualifications. You may be required to have a higher credit score or a certain percentage of equity in the home to qualify for a refinance. Home equity is the difference between the amount you owe on your current mortgage and the value of your house. If home values have dropped since you purchased your home, you may have less equity than you expect, disqualifying you from the refinance process.
The first step is to consider your options—shop around to see which lenders offer the most favorable refinance terms. Expect to pay 3 to 6 percent of your principle in refinancing fees. Things to consider include the interest rate, closing costs, points, possible prepayment penalties and loan term. You may want to hire an attorney to help you wade through the complicated paperwork, even if you didn’t hire one the first time around.
You can choose to change the length of your mortgage repayment period by switching from a 30-year to a 15-year mortgage, or vice versa. You can also move from an adjustable rate mortgage (ARM) to a fixed-rate mortgage. You can even choose to refinance for an amount greater than the amount you still owe on your home. This option, called cash-out refinancing, is useful for those who want to remodel or who just need money for a large expense such as their children’s education. These choices can affect both your monthly payments and your total long-term payment amount.
Should you Refinance?
Assuming you qualify for a refinance, it may or may not be a good option for you. You should consider refinancing if:
- interest rates are at least 1 or 2 percentage points lower now than they were when you took out your mortgage loan
- you have an ARM whose interest rate will be adjusting soon
- your income has changed since buying your house or may change in the near future
- you have sufficient equity in your home
- you will continue living in your home for long enough to reach the “break-even point,” the point at which refinancing will save you money (you must consider your monthly payments and closing costs to determine the break-even point)
- your credit score has improved
- you want to borrow equity from your home to fund a large expense
If you qualify for a refinance but don’t plan to stay in your home long enough to reach the break-even point, a refinance is probably not for you.
Downsides to Refinancing
While a refinanced mortgage can lower your monthly payments or interest rate, allow you to change mortgage types or provide you with cash when you need it, it’s not without a few downsides. For instance, defaulting on a refinanced loan could put you in bigger trouble than defaulting on your original mortgage—where you would have been facing foreclosure, you might face both foreclosure and loss of other assets, depending on where you live. Cash-out refinances can be especially risky and are not advised for those with a history of credit abuse.
Another downside is the illusion of saving money when you lower your monthly payments. If you refinance to a 30-year mortgage after you’ve already owned the home for five years, you’re stretching your payments over 35 years, which increases the overall amount you pay.
Similarly, a refinance may do more harm than good if you’ve owned your home for a while or if you plan to move soon. When you begin a mortgage repayment, you are paying mostly interest at first, and your payments shift over time to cover more principle. When you refinance, you will revert to paying mostly interest. This will slow down your growth of equity.
If you decide that a refinance is the most prudent option for you, the next step is to find out if you qualify. The process of applying for and obtaining a refinance is similar to a mortgage application, so be prepared to provide your mortgage lender with information on your credit, income, taxes and more. If done right, a refinance can be one of the easiest ways to save money, which can ultimately save you from financial trouble or aide in your investing endeavors.
