When you sign a mortgage, you commit to paying your lender a certain amount of money each month for the duration of your home loan's term. That amount is a function of the sum you borrow coupled with the interest rate attached to your loan.
But if you're having a hard time keeping up with your mortgage, or simply want to save money on your housing expenses, it could be beneficial to look into refinancing your mortgage rather than seeing your existing loan through until its term ends.
What is refinancing?
Refinancing means swapping an existing loan for a new one, and it's not just for mortgages. If you have student debt, for example, you can refinance your loans to lower your monthly payments or interest rate.
When you refinance a mortgage, you get an opportunity to change its terms for the better. You can refinance with your existing mortgage lender or with a new one, but generally, your goal should be to lower your interest rate as much as you can. The lower that rate, the lower your payments.
You can also refinance in a manner that changes the length of your mortgage. For example, if you originally signed a 15-year mortgage but have a hard time making your payments, refinancing to a 30-year loan stretches your repayment period out over more time, easing your burden.
What are the benefits of refinancing?
The whole point of refinancing is to save yourself money. Snagging a more favorable interest rate on your mortgage achieves that goal.
There's also the option to refinance your mortgage and borrow more than what you owe on your current loan to access money for other purposes. This is known as a cash-out refinance, and it's feasible if you have equity in your home.
For example, if you owe $120,000 on your mortgage but refinance to a $140,000 mortgage, you can get that extra $20,000 in cash. In many cases, you'll snag a lower interest rate on a mortgage than you will on a home equity or personal loan, so that's why this type of refinancing makes sense.
Furthermore, refinancing can help you pay off your mortgage faster. If you switch from a 30-year loan to a 15-year loan, you'll pay your home off in half the time, and generally at a lower interest rate (though in this situation, you can count on your monthly payments increasing, not decreasing -- even though you're paying less interest on the mortgage itself, you're accelerating your repayment schedule).
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What are the drawbacks of refinancing?
In the context of mortgages, refinancing comes at a cost. You'll need to assess your closing fees and make sure the savings involved are worth going through the refinancing process. And don't be fooled by those "no-fee" refinancing offers -- generally, those fees are just added to your loan balance or accounted for by not offering the most competitive rate.
Also, to be approved for your new loan, your home will need to go through the appraisal process like it did when you first signed a mortgage. If your home appraises for less than you expect, you may not get approved for a refinance.
Furthermore, if you refinance your mortgage in a manner that resets your repayment clock, you'll be paying that debt off for longer.
Say you're three years into a 30-year mortgage and you decide to refinance to another 30-year loan. You may manage to lower your interest rate and monthly payments, but you'll be back to square one as far as your repayment timeline goes. You can avoid this scenario by asking for a shorter mortgage term during the refinancing process, but banks are generally loath to agree to custom timeframes. And while you might snag a 20- or 25-year mortgage, a 27-year mortgage is very uncommon.
Is refinancing the right move for me?
If your credit score has improved significantly since you first applied for a mortgage, refinancing could render you eligible for a more favorable rate on your home loan. In this scenario, it pays to explore your options.
Refinancing only makes sense if you're planning to stay in your home long enough to reap some savings after your closing costs are accounted for.
Let's say your closing costs are 2% of your loan amount. On a $150,000 loan you're paying $3,000 to refinance. Now, let's assume that you stand to save $200 a month on your mortgage payments. This means it will take 15 months to break even before you start saving money. If you plan to remain in your home for the long haul, refinancing should work out in your favor. But if you're planning to move in a year, it's not worth it.
Refinancing your mortgage could be a smart move, but if you're going to go that route, be sure to shop around for the best rates. That way, you'll really make refinancing worth your while.