Are you thinking about refinancing? If you are, it’s important to understand refinancing pros and cons before making a decision.
But with so much information out there, sometimes it can be overwhelming to know where to start. We’ll dig into refinancing pros and cons to help you get the information you need to make the decision that’s right for you and your home.
What Is Refinancing?
Before we dive into some reasons to refinance your mortgage, let’s look at what it means to refinance.
The term refinance refers to a new loan with new term length, interest rate, or a modified loan balance. This new loan replaces the mortgage you currently have.
Refinancing your home means applying for and getting a new loan. You would use your new loan to pay off your current mortgage. Then you pay off your new loan, typically with monthly payments.
Common Reasons to Refinance Your Mortgage
While every situation is unique, there are some common pros and cons when it comes to refinancing your home.
The Pros Of Refinancing
The pros of home refinancing can include the following:
- Lowering your mortgage rate
- Lowering your monthly payment
- Switching the type of loan
- Shortening the term length of your loan
- Taking cash-out from your home equity
Lower Your Mortgage Rate
If you initially closed on your mortgage loan when rates were higher than they are now, you might be paying more than you have to. Applying for a new home refinancing loan could save you several hundreds of dollars or more over time.
Here’s how it might work
If your current mortgage is for $250,000 and your interest rate is 7%, your principal and interest payment is probably somewhere around $1,700 a month.
If you lower your mortgage rate by half a percent (0.5%) with home refinancing, your new mortgage rate would be 6.5%. That small drop in percentage means you could be looking at a monthly payment in the $1,600 range.
In other words, if you can reduce your interest rate by half a percent, you could save $100 a month or $1,200 in a single year. For a 30-year mortgage, that could add up to a savings of tens of thousands of dollars.
Lower Your Monthly Payment
Lowering your mortgage rate isn’t the only way you can lower your mortgage payment. Other ways to reduce the amount of money you need to pay each month can include getting rid of your mortgage insurance.
If your down payment was less than 20% when you purchased your home, and if you used a conventional loan, you had to pay for Private Mortgage Insurance (PMI). This insurance helps lenders minimize the risk of lending to someone with a downpayment of less than 20%.
To get rid of PMI, you might need to switch from your current type of loan to a fixed-rate or another loan. We’ll go into that in greater detail below.
Another factor to consider is your credit score. If your credit rating is better now than when you first applied for your mortgage, refinancing can result in a lower payment. If your credit score is in the mid-700s or higher, you can typically expect to get the best rate.
Switch to a Fixed Rate or Conventional Loan (from an Adjustable-Rate or an FHA Loan)
Switching to a fixed-rate or conventional loan from an adjustable-rate mortgage or an FHA loan can help you reduce the amount of money you have to pay.
- Adjustable-Rate: Low mortgage rates often attract borrowers to adjustable-rate mortgages (ARM). With an ARM, initial interest rates are lower than fixed-rate mortgages, making it easier to afford buying a home. An ARM can be an effective money management method if you refinance at the right time. In general, if you currently have an ARM, you can benefit from refinancing before mortgage rate adjustments increase. If your rate is about to go up, this might be an appropriate time to explore whether refinancing will be to your benefit.
- FHA Loan: If you took advantage of the Federal Housing Administration (FHA) benefits when you initially got your mortgage, you had to pay an additional fee: Mortgage Insurance Premium (MIP). MIP is one of the requirements for getting either an FHA loan or an FHA streamline refinance loan. To get rid of MIP costs, you might be able to switch from an FHA loan to a fixed-rate or conventional loan.
- Conventional Loan: Because the federal government does not insure them, conventional loans tend to have stricter eligibility requirements.
Conventional loans adhere to guidelines established by the Federal National Mortgage Association (Fannie Mae). These guidelines outline a framework that sets borrower requirements and maximum loan amounts, including better credit scores.
The good news is if you have really good credit, a conventional loan can help you save money by offering a significantly lower monthly rate, lower down payment requirements, and shorter mortgage terms. It’s important to note, however, that conventional loans typically require borrowers to meet stricter eligibility requirements, even with good credit scores.
Reduce the Term of Your Loan
When you refinance your mortgage loan, you can often reduce the duration of the mortgage or term length.
If your current mortgage payment period is 30 years, opting for a shorter-term mortgage of 10 or 25 years can reduce the amount of interest you pay overall. By making larger payments for a shorter time, borrowers can often save hundreds, if not thousands of dollars.
Take Cash-Out from Your Home Equity
Taking cash from the equity in your home allows you to convert your existing home equity into cash. Home equity is the difference between the amount still owed on your mortgage loan and your home’s current value, or what you have already paid off on your home.
The money you receive from a cash-out refinance can be used for home renovations, paying down debt, or other expenses of your choosing.
Cash-out refinancing is generally a straightforward process that can have lower interest rates than first-time mortgages.
The Cons of Refinancing
The cons of home refinancing can include the following:
- New or additional closing costs
- A low credit score or unemployment can negatively impact eligibility
- Break-even analysis: you may need to stay in your home longer than planned to break-even
New or Additional Closing Costs
Just as there were fees to service and close your original mortgage, there are closing costs to process a refinance loan. Not all refinancing loans are created equal, and some refinancing options come with additional closing costs. On average, these costs can range from about 3-6% of your mortgage’s principal.
While many programs allow for the closing costs to be included with your loan’s total amount, some require an upfront payment upon closing.
Low Credit Score or Unemployment Can Impact Eligibility
When it comes to refinancing, lenders consider different criteria to determine your eligibility.
Some programs, such as the FHA streamline refinance loan do not require proof of income or W2s from applicants. Some conventional loans, however, may not only run a credit check, but they may also charge higher interest rates if you have a lower credit score. Unemployment or unstable employment can impact eligibility in much the same way.
Break-Even Analysis: You May Need To Stay In Your Home Longer
Knowing the point at which you “break-even” will help you determine whether refinancing is worth your time and money. To do this, you’ll need to divide your total closing costs by your monthly mortgage savings.
Here’s how it might work
If refinancing saves you $100 monthly and your closing costs are $1,000, divide $1000 by $100. Your answer of 10 lets you know you’ll need to stay in your house for ten months to break-even, or to make the cost of closing worth the amount of savings.
Discuss Refinancing Pros and Cons for Your Specific Situation
Refinancing your home can offer numerous advantages, depending on your situation. One option might be better suited to you than another option.
We’d love to sit down with you and discuss refinancing pros and cons to help you decide which mortgage product is best for you. If you have questions or would like more information, reach out to the refinancing specialists at River City Mortgage today.
Photo by Tierra Mallorca on Unsplash