Refinancing a loan refers to the process of taking out a new loan to pay off outstanding loans, typically at a lower rate of interest. Refinancing a mortgage is a major financial move that can result in significant savings. However, this strategy can also backfire, making it important to know the right situations in which you should refinance. Furthermore, it can cost between 2%-5% of a loan’s principal, requires an appraisal and application fees making it a significant decision. Refinancing makes sense only if you will end up saving money and it won’t cause new problems for you. However, there are several other considerations to be made, including risk management, your credit score, other financial goals, and your refinancing break even point.
For many people, when mortgage rates nearly hit rock button or atleast fall below their current loan rate, it seems like a good time to refinance a mortgage. However, there are other good reasons to consider refinancing:
Refinancing to save money
Most online calculators will tell you a breakeven period based on cash flow indicating how long it will take to recoup any closing costs after accounting for a new (lower) monthly payment. However, you will usually need a more thorough review of how interest costs will change. To determine you’ll save money, you will need to run the numbers yourself. For example, if your current mortgage is a 30 year fixed rate loan of $200,000 with a 5% interest rate, you’ll have paid $48,076 in interest by year five and you will pay $186,512 in interest over the life of the loan. If you refinance after five years to a 3% fixed interest rate on a 30 year loan, you’ll only pay $95,252 in total interest on the new loan. Even added to what you paid so far on the old loan, you still come out ahead at $143,328 in total interest; a saving of $43,183. You can use an amortization calculator to make these calculations easier.
Refinancing to cash out your equity
Sometimes homeowners tap into their home equity with a cash out refinance to raise funds to pay for other financial goals such as education or a new business. However, a cash-out can be risky because your house is now on the line, making it important to keep up with your new mortgage.
Refinancing to consolidate your debts
You might also take cash out to consolidate high interest rate debts. This plan could be beneficial since home loan rates are usually much lower than credit card interest rates. However, if you refinance unsecured debts with a secured loan, you are taking additional risk. For instance, you might use a home equity loan to pay off a credit card debt. In the case that you default on the credit card debt and have pledged your home as collateral, your home might be foreclosed by the bank.
Refinancing to shift from ARM to a fixed rate mortgage
In some cases, refinancing can be a good idea, even without a lower rate or a shorter term. For instance, if you are worried about increasing interest rates in the future, refinancing from an ARM to a fixed rate mortgage reduces that risk.
Things to watch out for when refinancing
If you are considering refinancing, do ensure to look into the following:
Is it ever wise to consider refinancing with rising rates?
If rates are increasing, it might be better to consider refinancing now as opposed to later when they might be higher. First you’ll need to look at how far you are into your current mortgage and determine your Combined Loan to Value (CLTV) ratio which compares your loan balance to your home’s value and indicates all lines of credit that you may have open on your home. The lower the percentage is, the better. However, in general these are a few times refinancing during a period of rising rates can be a good thing:
Although every situation is different and must be evaluated independently, a few criteria can be considered before thinking about refinancing. Check if current interest rates are at least 1% lower, you plan on staying in your home for another 5 years and you anticipate being approved for the refinance loan based on your credit score. Do not jump into refinancing, because it can cost your home and compel you to compromise on other financial goals if it backfires. The final takeaway must be to figure out what your total costs, new monthly payments be and make a wise decision.