Pros and Cons of Refinancing Your Mortgage
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Refinancing your home loan can lower your lifetime interest costs and reduce your monthly payment, among many other benefits.
However, you’ll want to evaluate the pros and cons of a mortgage refinance before you apply. This will help you determine if refinancing is the right move for you.
Here’s a closer look at the advantages and disadvantages of mortgage refinancing:
Pros of refinancing your mortgage
There are several advantages to refinancing a mortgage, including a potentially lower interest rate.
Lock in a better interest rate
A lower rate can reduce your lifetime interest costs by thousands of dollars. Consider refinancing when mortgage rates begin to dip. Most experts agree that you should consider refinancing if you can lock in a rate that’s 0.75 percentage points lower than your current rate.
You may also be able to lock in a better rate if your credit score is higher than when you took out your original mortgage.
Lower your monthly payment
It’s possible to reduce your monthly payment through a mortgage refinance. You can potentially get a lower interest rate or extend your repayment term — or do both. If you’re currently struggling to pay the bills and want to keep your home loan in good standing, refinancing might be a necessary option.
If you think refinancing is the right move, Credible makes it easy. You can compare multiple lenders and see prequalified rates in as little as three minutes without leaving our platform.
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Checking rates will not affect your credit
Tap into your home equity
A cash-out refinance can help you tap into your home equity. You’ll pay off your original mortgage with a newer, larger loan and receive the difference in cash.
You can then use the distribution to fund home improvement projects or other expenses, like credit card debt or a down payment on an investment property.
Enjoy more predictable payments
If you currently have an adjustable-rate mortgage (ARM), refinancing to a fixed interest rate will provide more stability in your monthly principal and interest payments. With a fixed-rate loan, you’ll pay the same amount every month for the entire loan term. This makes your mortgage payment easier to budget for and provides you with some peace of mind.
Avoid mortgage insurance
Refinancing into a conventional mortgage with at least 20% interest waives private mortgage insurance (PMI) charges. This is also a way to get out of paying mortgage insurance premiums on an FHA loan.
Cons of refinancing your mortgage
Here are some of the drawbacks that accompany mortgage refinancing.
Need to pay closing costs
Just like a new home loan, you must pay closing costs with any mortgage refinance loan. These fees are approximately 2% to 5% of your loan amount.
Some of the fees you can expect to pay include:
- Origination fees
- Home appraisal
- Title insurance
- Credit report fee
You may be able to roll some of the fees into your new mortgage, but this may increase your loan APR and lifetime interest costs. A mortgage payment calculator can help compare your upfront costs and potential lifetime interest costs.
If you’re planning on selling your home in the next few years, you’ll want to find your breakeven point — the point at which you’ll recoup your closing costs — to determine if refinancing is worth it.
Monthly payments could be higher
Switching to a shorter repayment period, such as 15 years instead of 30 years, will most likely increase your monthly payment as you have fewer years to pay off the loan principal. Deferring your closing costs can also increase your payment.
On a positive note, you’ll be out of debt faster and pay less interest by opting for a shorter repayment period. If you can afford the higher monthly payments, it’s a good option to consider.
Might increase the overall cost of your loan
Extending your repayment term can increase your total interest costs even if you get a lower interest rate or smaller monthly payment.
Here’s an example of how much more your total interest costs can be when refinancing to a 30-year term. This example assumes a current mortgage balance of $226,445 with 25 years remaining on an original 30-year term.
|Existing mortgage||Refinance mortgage|
|Starting loan balance||$250,000||$226,445|
|Total interest cost||$184,356.61||$199,916.59|
While it’s possible to refinance to a lower interest rate and monthly payment, your total interest cost can still be higher. For this example, your new loan APR must be at least 0.70% lower than your original rate before you reach your breakeven point and start saving money.
And, assuming you don’t pay off the loan early or sell your home, refinancing your mortgage keeps you in debt longer, which might make it more difficult for you to achieve other financial goals.
Must qualify for refinancing
In addition to paying closing costs, the underwriting process requires you to satisfy your lender’s mortgage qualifications for income, credit, and debt.
Some of the mortgage refinance requirements include:
- Credit score: Traditional lenders require a minimum 620 credit score. Most lenders offer the lowest refinance rates to homeowners with an excellent credit score of at least 740.
- Steady employment: You’ll need at least two years of reliable employment and income statements, and you may also need to show proof of sufficient cash reserves.
- Home equity: Many lenders require you to have at least 20% equity in your home to refinance your mortgage.
- Home appraisal: A home appraisal verifies your property value is higher than your requested loan amount. You may need to postpone refinancing if your mortgage is underwater since this means you owe more than the home is worth.
Alternatives to refinancing your mortgage
If you’re content with your current mortgage rate and term, but you still want to access your home equity, consider either a home equity loan or a home equity line of credit (HELOC).
These two options generally have lower closing costs and might be a better fit than a cash-out refinance.
Apply for a home equity loan
A home equity loan lets you borrow up to 85% of your home equity as a lump-sum payment. You repay your principal and interest with fixed monthly payments, similar to a fixed-rate mortgage. Depending on your loan terms, your repayment period can be as long as 30 years.
Here are some of the advantages of home equity loans:
- Can use funds for different purposes: You can use your funds for a variety of expenses, including home repairs, medical bills, and debt consolidation.
- Potential tax deductions: In many cases, your interest payments are tax-deductible for home repairs and capital improvements for your primary residence.
- Fixed interest rate: Lenders offer fixed interest rates so you have the same monthly payment for the life of the loan.
Some of the disadvantages of home equity loans include:
- Lump sum payment: You receive your entire loan amount upfront and cannot request future withdrawals. If you don’t need to spend the entire amount immediately, consider a HELOC, which allows you to make distributions as needed.
- Higher monthly payments: Your monthly payments can be higher than a HELOC as you start repaying the principal right away. You’re also accruing more interest than with a HELOC as your starting balance will most likely be higher.
- Secured debt: Home equity loans are secured debt, meaning your home is collateral. If you default on the loan, your lender has the right to foreclose on your home.
Apply for a home equity line of credit
A home equity line of credit (HELOC) can be a good decision if you want to borrow from your home equity several times.
Unlike a home equity loan, you won’t receive a lump-sum payment. Instead, you’ll make withdrawals as needed during the draw period, which is usually 10 years.
A HELOC offers many advantages, including:
- Potentially less interest: With a HELOC, you only have to pay interest on what you borrow. Your total interest costs, in turn, might be lower than on a home equity loan that distributes the entire loan amount upfront.
- Flexible withdrawal policy: You can withdraw as little or as much as you need during the draw period, up to your credit limit.
- Interest-only payments: Your lender may only require monthly interest payments during the draw period. However, there is no penalty to pay back the outstanding principal early.
Some of the disadvantages of a HELOC include:
- Variable interest rate: Most HELOCs have a variable interest rate. If you’re not comfortable with a variable interest rate, fixed-rate HELOCs do exist, but they’re more rare.
- Shorter repayment period: Your repayment period may be shorter than a home equity loan, meaning your monthly payments could be higher once you start paying off the loan. Most HELOC repayment periods are between five and 20 years.
- Secured debt: A HELOC is using your home equity as collateral. As a result, your lender may foreclose on your home if you cannot pay off your credit line before the repayment period ends.
When to refinance your mortgage
Generally, refinancing is a good decision if you find yourself in one of these situations:
- You qualify for a lower interest rate
- You want to shorten your loan term
- Your interest savings exceed the closing costs
- You can afford the new monthly payment
- You’re struggling to make your mortgage payments
- You want to switch from an adjustable-rate to a fixed-rate mortgage
How to apply for a mortgage refinance
Here are the steps you can expect to take when refinancing your mortgage:
- Compare rates with different lenders. Aim to get rate quotes from at least three different lenders. This will ensure you receive a competitive rate. Credible can help you compare rates from multiple lenders without hurting your credit score.
- Gather and submit financial documents. After choosing your lender, gather the necessary paperwork and submit it to start the application process. You’ll want to have your tax returns, bank statements, and proof of homeowners insurance at the ready, among other documents.
- Get a home appraisal. Your lender will require a home appraisal to determine what your home is worth and how much equity you have.
- Sign your closing documents. After completing the underwriting process, you’ll pay your closing fees and sign the closing forms. Your new rate and term become effective immediately and replace your existing mortgage.
Keep Reading: How to Refinance Your Mortgage in 6 Easy Steps