Refinancing your mortgage insurance policy can be a smart financial decision. It can lower your monthly installments or help you save money on total interest rate over the life of the mortgage loan. But it can also cost money if you do not think it through.
Continue reading to find out what mortgage refinancing is and when it is a good idea to do refinance your mortgage and when it is not.
What is mortgage refinancing?
Mortgage refinancing entails getting a new mortgage to replace the original one, ideally at a better interest rate. For the right kind of borrower, refinancing offers several advantages, like lower monthly repayments and a chance to pay off the loan sooner.
Consider this scenario: Let’s say you took a 30-year fixed home loan at an interest rate of 3.67 percent. But now, a year down the line, the mortgage rate is hovering around 2.80 percent. In this scenario, refinancing your mortgage can potentially save you money.
However, the equation is not always as simple as comparing the mortgage rates for which you qualified earlier with the interest rates you can get now. Before you make the decision, consider factors like the cost of getting the new mortgage and after-tax monthly savings.
Reasons you should not do a mortgage refinance
Refinancing your mortgage is not always a good thing. Sometimes it does not make financial sense to do a mortgage refinance, for instance in these circumstances:
1. To consolidate debt
Debt consolidation entails combining several smaller loans into one loan by taking out a new loan to pay them off. When done right, it makes paying off the debt much simpler and can even result in lower monthly repayments. But when done wrong, it can have dire consequences — especially when your home is on the line.
On the face of it, paying down high-interest rate loans with a low-interest home loan appears to be a smart financial move. However, there are serious pitfalls that you must take into consideration.
Consolidating your debts with a mortgage refinancing basically means using your home as collateral. If you default, you run the risk of foreclosure. While missing a personal loan or credit card debt repayment has negative consequences, they are generally not as serious as losing your home.
A reputable mortgage broker can help you to refinance your mortgage to consolidate debt in a responsible way.
2. To move into a longer-term loan
You can save money on your monthly installments by refinancing into a home loan with a lower interest rate, but do not forget to take the overall cost into account. For example, if you have only 18 years left on the mortgage and you refinance your mortgage into a 30-year home loan, you will not only end up paying the installments for a longer period but will also pay more in interest.
3. You cannot afford the closing costs
Mortgage refinancing can lower the monthly installments and even help you pay off the loan sooner. But these benefits will count for nothing if you do not have enough cash to pay the closing costs upfront. Of course, adding them into the home loan is an option, but it will significantly reduce your savings from refinancing.
4. To switch from a fixed-rate to an ARM
You can opt for either a fixed-rate mortgage or an adjustable-rate mortgage (ARM). Your rate remains the same throughout in the case of a fixed-rate mortgage. An ARM, in contrast, locks in the rate for a limited period, usually 5 years. After which your rate adjusts — generally once a year — to reflect current market rates.
Since an ARM does not lock your rate in for a long period, the initial rate may be lower than that of a fixed mortgage. This may tempt you to switch from a fixed-rate mortgage to an ARM to score a lower rate for the first 5 or 8 years.
But this might not be a smart move because you do not know how strong the economy will be once your rate starts to adjust.
5. To make the most of a no-closing-cost mortgage refinance offer
There is no such thing as a no-cost mortgage refinance. If you see such an offer, do not believe it for a minute. When you buy a house, you will have to pay the closing costs one way or another.
A no-closing-cost mortgage refinance is a refinance option that does not require paying the closing costs upfront. But this does not mean your mortgage lender will foot the bill for free. Instead, it will either roll them into your mortgage or hike up your interest rate in exchange.
Either way, you will be the one who will pay the closing costs.
6. Poor credit score
Has your credit score fallen since you applied for your first mortgage? If so, refinancing the mortgage is a bad idea. You could end up with a mortgage rate that is higher than your current rate. Moreover, if your score has plummeted sharply, you might not even be approved for a loan for a mortgage refinance.
7. You plan to move soon
If you plan to move out of your home soon, the benefits—such as a better rate—are not likely to be enough to offset short-term costs. Before refinancing, figure out when you would reach the break-even point. This is the point when your savings from refinancing equals the cost of fees.
If you think you will sell the house before the break-even point, refinancing is not for you.
8. To offset Covid-19 related financial distress
If the Coronavirus has impacted your finances, you might be considering refinancing to make your monthly installments more affordable. While this is not a bad idea, chances are it is already too late for that. If your household income has already reduced, your application is not likely to be approved.
But if you believe your employer may furlough you in the near future, refinancing can be a good move.
Risks of refinancing
Before you do a mortgage refinance, check if you will have to prepayment penalty and, if yes, how much. Your mortgage lender may charge you a fee for paying down the loan before your term is up. This fee is called the prepayment penalty or prepayment charge and often runs into thousands of dollars.
Make sure the refinancing agreement covers the prepayment penalty and is still profitable.
When refinancing your mortgage is a good idea
Generally speaking, refinancing is a good decision if it will save you money, allow you to pay off the loan sooner, and help you build equity.
Let’s take a closer look at different scenarios in which refinancing can be advantageous.
1. Lower interest rate
Mortgage payment rates are not set in stone. The rate you qualify for depends on several factors, like the overall economic situation, your credit score, and your property. If the rate available to you today is considerably lower than your original rate, refinancing might save you money. Generally speaking, refinancing is a good idea if you can lower the interest rate by at least 1%.
2. To change your loan term
Refinancing can be a good strategy if you need to increase or reduce your loan term.
Longer mortgage term
Finding it difficult to manage monthly mortgage payments? Increasing the term length — say from 15 years to 30 — can lower the amount the monthly installments. But keep in mind that mortgage lenders offer lower interest rates for shorter mortgage terms. So, if you lengthen the term, you will likely end up paying more in interest over time.
All the same, if your current financial situation makes it difficult to keep up with the mortgage monthly payment schedule, refinancing can help free up more cash for other necessary expenses.
Shorter mortgage term
You can also switch from a longer mortgage term to a shorter one. Doing so will means you will pay less interest over time. That is because:
- Your new interest rate is likely to be lower than the previous interest rate. (As said before, shorter mortgage terms have better interest rates)
- You will pay your home loan faster
But remember you will be paying more money each month. Before you sign up the refinancing agreement, ensure your current budget can accommodate the increase.
3. Cash out
You may consider cash-out refinance if you need to borrow money to cover a big expense, like a child’s college education. Your old home loan will be replaced with a new, bigger loan. You are likely to pay on a cash-out refinance, compared with rate-and-term refinance. Nevertheless, using the home loan to get some cash may be a sound financial move if there is no better way to borrow money.
Key things to keep in mind are:
- Your mortgage will be refinanced for a larger amount than what you presently owe
- Your house will still serve as collateral. If you default, you run the risk of foreclosure
- The higher your credit score, the better the cash-out rate
4. For a house buyout in a divorce
If you want to keep the house after separation, refinancing the mortgage to buy out your ex-spouse can be a good decision. The advantages are obvious. For one, you get to keep the house to provide stability and continuity for the children. Two, you do not have to sell it if the market is not favorable.
Conclusion — is refinancing your mortgage worth it?
Refinancing the mortgage can be a good financial move for some homeowners. If you will save money, be able to pay off the loan faster, and/or build equity, refinancing is worth it. In contrast, if your credit score is poor, you cannot afford the new monthly installments or refinancing fees, or you will move before reaching the break-even point, it is probably a bad idea. Review your unique financial situation first to see whether refinancing your mortgage makes sense.