Once you've completed the home purchase process and you're officially a proud homeowner, each month you're committed to making a mortgage payment. These monthly payments span the term of your mortgage, which might be 10 years, 30 years or something in between. However, before you reach the end of this term, you may want to consider refinancing.
There are some different flavors to refinancing, such as lowering your rate, taking cash out, adjusting your term, or changing from a fixed rate to an adjustable rate or vice versa. No matter the type of refi you choose, at the end of the day, refinancing is frequently a means to an end—it can be a smart way to increase cash flow, consolidate high-interest debt or pay less on your mortgage over the long haul. In this month's Insights, we discuss various factors to weigh when deciding if now is the right time to refinance.
Solution 1: Increase Cash Flow by Refinancing at a Lower Rate
One of the more apparent reasons to consider a refinance is to take advantage of lower interest rates—with the goal of ultimately lowering your monthly mortgage payment. Remember, your monthly mortgage payment is comprised of principal and interest, in addition to other things. The principal portion you pay goes toward paying down the amount of money you borrowed. The interest portion goes toward your bank or lender and thus could be considered the cost to borrow. So refinancing to a lower interest rate means you'll put more money in your pocket in each month since you'll pay your lender less interest.
While you likely save on interest by refinancing into a lower rate, you do have to remember that you're restarting the clock on your loan and that refinancing typically comes at a cost. Your lender can likely walk you through how much interest you will pay over the remainder of your loan versus how much interest you would pay over the life of a new loan. That way you can compare your savings and determine if a refinance is worth the upfront cost.
Solution 2: Fund a Goal through a Cash-Out Refinance
When you refinance your home to take cash out, you refinance your mortgage at a higher balance and receive the difference in straight cash funds. One of the most important things to keep in mind is that you should have a clear purpose for the cash out. The funds can be applied toward large bills, a car, a down payment on another home or a renovation. Your lender will want to know how you plan to use the money, though ultimately, you have the flexibility to responsibly use the money as you choose. The word responsibly is key here. After all, this type of refi uses your home as collateral—meaning if you aren’t able to repay the loan, your home is on the line.
A cash-out refinance isn't for everyone. There are instances where it can affect the benefits Servicemembers on active duty and their co-borrowers are entitled to under the Servicemembers Civil Relief Act or applicable state law. So if you fall into that category, you'll probably want to get more information first. A cash-out refinance is for those who own more than 20 percent of their home. There are a few ways of accomplishing this over time. For one, those that have been paying off their mortgage month-to-month may have built up significant equity in their home that they can now leverage. Another consideration is whether your home value has significantly increased, in which case you will have more flexibility with how much you can borrow on your mortgage. Ultimately, the general rule of thumb is that a lender will only lend up to 80% of the value of your home when approving a cash out refinance.
Lastly, it is particularly important to keep in mind that you are subject to a new interest rate when raising your loan amount through a cash-out refinance. Both your current balance plus any additional cash out will be refinanced into a new rate. As such, if rates aren't the same or more favorable than your current rate, it might make sense to leave your first mortgage as is and explore a home equity line of credit or second mortgage.
SOLUTION 3: PAY LESS INTEREST BY REDUCING THE LOAN TERM
A lot can happen over the course of just a few years of homeownership. Maybe your financial situation has changed for the better since originally financing your home. If you're fortunate enough to be in this bucket, refinancing with a shorter term could be an option for you. Rates on shorter terms are typically lower. Plus, opting for a shorter term, e.g. 15-year mortgage versus a 30-year mortgage, means you'll pay off your mortgage quicker and significantly reduce the amount of interest you pay over the long haul. It's important to remember that refinancing at a shorter term will probably increase your mortgage payment.
While it's a responsible goal to pay your mortgage off as quickly as you can afford, you shouldn't stretch your monthly cash flow too thin in case any roadblocks ever pop up. As a general rule of thumb, you should also keep a few months of mortgage payments saved up for that same reason. However, if you do have some flexibility in your budget, a shorter mortgage term with a lower rate might save you a lot in interest over time.
Solution 4: Align Your Mortgage with Any New Plans You’ve Made
Going back to the idea that a lot can change over time, maybe your plans have changed since you originally purchased the house. If you're currently in a fixed rate mortgage but are now planning on moving within the next 5-7 years, it might make sense to refi into an adjustable rate mortgage (ARM). ARM rates are typically lower than fixed rates, so with an ARM, you'll lock in a low rate for a preset number of years. Then once you've reached that period, rates will fluctuate based on the market thereafter. The idea here would be that you'd pay less in interest during that preset period and not have to worry about your rate adjusting with a move planned.
On the other hand, if you plan on staying in your home for a longer term, a fixed rate mortgage might be a more stable option on your budget, especially if you think rates are going to rise.
Is a Refinance Right for You?
While it is called a refinance, you are technically paying off your existing mortgage and establishing an entirely new mortgage with a new rate and new term. As such, you should weigh all of your options to determine if this is the right move for you. A quick conversation with your lender can help you talk through your options and consider the financial implications of a refinance.