Pros And Cons Of Refinancing A Mortgage

Homeowners with a mortgage may have the option to refinance into a new home loan to shorten their term, lower their mortgage rate or use their equity to meet other financial needs – but there are drawbacks they’ll need to consider before taking advantage of this loan option. Why? Because it could end up costing them more money or be more work than it’s worth.

If you’re considering getting a new loan, weigh these pros and cons to decide whether you should refinance.

Pros Of Refinancing

There can be major benefits of refinancing a mortgage, but the pros depend on the terms of the refinance and your individual situation and goals. And while you can get the following benefits from a refinance, there may be some trade-offs.

1. You Could Pay Off Your Loan Faster

You can refinance your mortgage into a new loan with a shorter term (for example, going from a 30-year loan to a 15-year). By shortening your loan term, you’ll gain more equity in the home faster and pay the loan off quicker. That means you’ll own your home free and clear earlier and reap such benefits as saving money on interest and having more money each month when you no longer have a mortgage payment.

2. You Might Spend Less Over The Life Of The Loan

When you shorten the length of time you take to pay off the loan, you shorten the length of time you pay interest on that loan, meaning you’ll pay less interest over the life of the loan. But what about if you don’t shorten the length of the loan? You could still end up paying less over the life of the mortgage.

If your refinance rates are low, you may be able to lower your interest rate. Since you pay interest until you pay off the loan, this will save you on the amount of total interest you pay over the life of the loan.

Here’s an example:

You get a 30-year mortgage for $200,000 at 4%. In 2 years, you’ll have already paid $15,728 in total interest. If you keep this original loan for 30 years, you’ll end up paying $143,739 in total interest over the life of the mortgage.

Let’s say, after 2 years, you refinance the loan into a new, 30-year mortgage at an interest rate of 3.5%. Since you paid the loan for 2 years, your loan balance is now $192,812. If you kept the new loan for 30 years, you would pay $118,880 in total interest over the life of the new loan.

Now, add the 2 years you paid interest on the original loan, and you’ll pay a total of $134,608 in total interest. With just the original loan at a 4% interest rate, you still would’ve paid more. By refinancing to the lower interest rate, you save $9,131 in total interest paid over the life of the loan.

3. You Could Save More Each Month

If you refinance to the same term as your original mortgage, you’re further extending the time you have to pay off the loan, meaning your monthly payment will go down. And if you can refinance the loan with a lower interest rate, your monthly payment could go down even more.

Here’s an example of how your payment would go down.

We’ll use the same numbers as the example above. Keep in mind that these monthly payments do not include escrow.

You get a 30-year mortgage for $200,000 with a 4% interest rate. Your monthly payment is $954.

You refinance your loan after 2 years to another 30-year mortgage and keep the same interest rate. Since you’ve been paying for 2 years, your loan balance is now $192,812. By having a longer term and extending it back to 30 years, your monthly payment is now $920.

Let’s say rates were low when you refinanced, so you also lowered your interest rate. Your new 30-year mortgage is $192,812 with a 3.5% interest rate. Now your monthly payment is $865.00.

4. Payments Can Become More Predictable

If you have an adjustable-rate loan, you can refinance a fixed-rate mortgage instead. With an adjustable-rate loan, your interest rate changes over time, based on the market. That means it can rise or fall – and your monthly payment will do the same.

With a fixed-rate loan, your interest rate stays the same throughout the life of the loan. This makes monthly payments more predictable because your combined principal and interest payment will stay the same. Remember that your escrow payment may fluctuate as property tax and insurance costs rise or fall. This consistency can make budgeting easier.

5. Cashing Out Equity Can Cover Some Expenses

If you want to pay down and consolidate your debts or make improvements to your home, a cash-out refinance can help you do that by allowing you to borrow against the equity in your home. You’ll simply borrow more than you currently owe (as long as you have that much equity) and keep the difference.

Here’s how it works, using real numbers.

You currently have a loan for $150,000 and your home is worth $200,000. Right now, you have $50,000 in equity. You’d like to pull out $20,000 to finish your basement, so you refinance and borrow an additional $20,000. Your new loan balance is $170,000 ($150,000 + $20,000) and you still have $30,000 of equity in your home.

Cons Of Refinancing

Refinancing isn’t a good idea for everyone and there are several reasons not to refinance, depending on your situation. Below are some downsides to refinancing you may consider before applying.

1. You Might Not Break Even

While you may save money with a refinance, it’s important to remember that there are costs involved in refinancing that could potentially nullify this benefit or weaken it.

For example:

Using the example in Pro #2, you refinance your loan after 2 years and your new loan balance is $192,812. Because you lowered your rate, your savings in total interest paid is $9,131 (after adding in the 2 years of interest you paid before refinancing). However, if your closing costs were between 2 – 3% of your loan balance, it will cost you between $3,856 – $5,784 in closing costs. For simplicity’s sake, we’ll say that you pay these closing costs at the closing table, out of pocket, and don’t roll them into your loan, like a no-closing cost refinance would. When you subtract closing costs from the amount you’ll save, you’ll really only save between $3,347 – $5,275 overall.

Remember, too, that the savings are often long-term savings, so you’ll need to decide whether the upfront costs now will be worth the savings you’ll have to wait for in the future. This is especially important if you think you’ll sell or move before the breakeven point.

2. The Savings Might Not Be Worth The Effort

As you see in the example above, the savings from a refinance might be minimal and you’ll need to consider if they’re worth the work put into refinancing your loan and the length of the refinancing process. Even when the process is streamlined and smooth, it’ll still require some effort on your part, including applying for the new loan, providing financial documents and getting an appraisal.

3. Your Monthly Payment Could Increase

If you refinance from a 30-year mortgage to a 15-year mortgage, your payment will likely increase because you are shortening the amount of time you have to pay off your loan.

Here’s an example:

You have a 30-year mortgage for $200,000 with a 4% interest rate. Currently, your monthly payment is $954 per month, not including escrow.

You refinance a 15-year mortgage for $200,000 with the same interest rate. Now, your monthly payment is $1,479.

Even if you refinance into a lower interest rate, your monthly payment could still increase. For example, if you refinanced into a 15-year mortgage for $200,000 with a 3.5% interest rate, your monthly payment would be $1,429.

4. You Could Reduce The Equity In Your Home

A cash-out refinance allows you to borrow against the equity in your home. That means, you’re using the equity in your home, which will reduce it. So, if you have $50,000 equity in your home and take $20,000 out in a cash-out refinance, you’ll have $30,000 equity left.

How Can You Save Without Refinancing?

Refinancing a mortgage can be valuable to some borrowers, but it isn’t suitable for everyone. Here are a few other options for you to consider when trying to save money on interest:

Make extra principal-only payments: These payments go towards the principal and lower the amount of the interest you’ll pay over your loan term.

Use a personal loan: A personal loan helps you save on money through two types of loans, secured and unsecured. A secured loan offers lower interest rates, whereas an unsecured loan doesn’t require you to provide collateral (e.g., assets or property) to the lender. A personal loan will come at a lower interest rate than a credit card.

Get a home equity loan or home equity line of credit (HELOC): A home equity loan and HELOC use your house as collateral. With HELOC, you can also borrow money up to the credit line and repay the amount with interest. If you have enough equity and need the money, these options can help you borrow at a lower rate.

Apply for a 0% interest credit card: These credit cards can serve as an interest-free option, but this option is only available for those with an outstanding credit score.

The Bottom Line: Pros And Cons Aren't One Size Fits All

The pros and cons of refinancing will be different for each person and depend on your unique situation and individual goals. As you try to figure out if you should refinance your mortgage, decide why you want to refinance and determine if it will benefit you based on what interest rates are, how long you’ll extend or shorten your loan term and how long you plan on staying in the home.

It’s important to speak to a Home Loan Expert who can help you determine the best refinance for you, or even help you explore other loan options if there’s a better fit with a different product.