Refinancing is taking out a new mortgage, often with better interest rates and terms, to pay off your old mortgage. But there are other reasons to refinance, and when refinancing you should have a goal in mind. Do you want to lower your monthly payments? Save interest over the life of your loan? Use your home equity to pay for college expenses? Your goal will determine which type of refinance mortgage is right for you.
It’s important, however, to understand the differences between the types of refinancing available, along with their costs and benefits, before deciding which option is right for you.
What type of refinancing is right for you?
1. Rate and Term Refinancing
For many people, the aim of refinancing is to either lower their monthly payments, pay their mortgage down faster, or reduce the amount of interest on their loan. These homeowners generally wish to keep their loan amount the same, while simply changing the way they pay it off. This is called rate and term refinancing, and it may be desirable:
- To get a better fixed interest rate.
If interest rates have fallen since you took out your mortgage, refinancing may enable you to get a better rate and lower monthly payments. For example, a $160,000 fixed rate mortgage with a 30-year term at 8 percent requires a monthly payment of $1,175. Lowering the rate to 6 percent drops the monthly payment to $960.
- To stabilize your payments.
Perhaps the interest rate of your adjustable rate mortgage has gone up every adjustment period and you’re concerned the trend will continue. Locking it in for a fixed term at its current rate may mean higher payments initially but will prevent you from being hit with increasing monthly payments should interest rates continue to rise.
- To obtain better loan features.
Your credit rating might have been mediocre when you took out your mortgage, but it has since improved. Refinancing may enable you to get a lower rate or, in the case of an adjustable rate mortgage, a more protective cap (a limit on how much your payments can increase).
- To build your home equity more quickly.
A recent change in your financial situation may make it possible for you to pay off your loan faster by increasing your monthly payments. Refinancing a 30-year $100,000 mortgage at 6 percent with a 15-year $100,000 mortgage at the same rate would raise your monthly payments from $600 to $844 but allow you to pay down the principal in half the time and save you almost $64,000 in interest over the life of the loan. However, you can also build equity more quickly without refinancing by making additional principal payments each month.
- To reduce your monthly payments.
If you are having difficulty meeting your monthly payments, you may wish to refinance your mortgage for a longer term. For example, increasing the term of a $150,000 mortgage at 7 percent from 15 years to 30 years would reduce your monthly payments from $1,350 to $1,000.
2. Cash-out Refinancing
The other major category of refinancing involves taking out a new mortgage with a larger principal than the one you’re currently carrying. This is called cash-out refinancing and its goal is not simply to pay less interest, but to turn some of your home equity into cash. (Remember, though, that the loan is secured by your home.) For example:
- To free up money for a major expense.
You may have built up $180,000 in equity after 20 years of mortgage payments, and now you have two children whom you want to help through college. Rather than taking out a personal loan (which generally carries a higher interest rate with no tax advantage), you can refinance your mortgage, adding $40,000 to the principal, and use that money for tuition.
- To consolidate debt.
Perhaps you have $50,000 in credit card debt with interest rates as high as 18 percent. Now that you have curtailed your spending, you decide to refinance your mortgage, adding $50,000 to the principal and locking it in at 6 percent. This will allow you to consolidate your debt and pay it off at a third of its present rate.
- To combine first and second mortgages.
If you have a first mortgage of $100,000 and a home equity loan of $30,000, each with a different lender, you may wish to raise the principal of your first mortgage to $130,000 to cover both loans, with the aim of getting a better rate and more convenience.
Is refinancing right for you?
As there is a cost involved with refinancing, you must determine whether refinancing makes financial sense for you. The benefits of refinancing add up over time, so if you’re planning to move in a year or two, any potential savings will likely never be realized. In addition, factor in that you may be extending the time it takes to own your home “free and clear.” In general, the longer you plan to stay in your current home, the more sense it makes to consider refinancing.
Next step: Compare offers.