Miranda Crace7-minute read
UPDATED: April 06, 2023
From lowering your monthly payment to extending your loan term, there are many reasons a homeowner might consider refinancing their mortgage. But how do you know if this decision is right for you?
In this article, we’re breaking down the pros and cons of refinancing to help you choose the best path to reach your financial goals.
There’s a lot to mull over when considering a home refinance. The type of mortgage, loan term, interest rate and market conditions will all play a role in deciding whether this option is suitable for your needs. But in general, there are a few potential benefits to keep in mind.
By refinancing your home loan into one with a shorter loan term – for example, refinancing from a 30-year to a 15-year mortgage – you can build equity in the home at a faster rate, which means paying off the loan sooner. Not only does this mean owning your home in full but paying off your mortgage faster can also mean saving money on interest paid.
If you opt to reduce the loan’s term, you’ll end up paying less in interest over the lifetime of the loan – but that’s not the only way that refinancing can save you money on your home. Depending on when you refinance, you may also be able to obtain a lower interest rate.
Of course, a lower interest rate will also mean paying less over time. To illustrate, let’s break it down with an example.
Say you start with a 30-year mortgage with a loan amount of $300,000 and an interest rate of 6%. If you stick with the original loan terms, you’ll wind up paying $347,515 in interest over the lifetime of the loan.
Now let’s pretend you choose to refinance this mortgage after two years making payments. At the two year mark, you will have paid $34,109 in total interest and brought your loan balance down to around $292,740.
If this loan is refinanced into a 30-year mortgage with a lower interest rate of 5.5%, you’ll pay $305,632 in interest. So, even when we add in the interest you’ve paid so far, this refinance still saves you upwards of $8,000 in total interest paid over the lifetime of the loan.
On the other hand, let’s say your interest rate stays the same at 6%, but you refinance to shorten your loan term from 30 to 15 years. In this scenario, your total interest paid becomes $189,792, including the $34,000 already paid.
Refinancing for the same term – for example, refinancing a 30-year mortgage into a new 30-year mortgage after a few years of making payments – can also lower your monthly payments.
The reason for this is simple: when you refinance, the 30-year term is starting over, giving you more time to pay off the remaining balance of the loan, which therefore lessens the monthly cost.
So, following the same example as above, your original monthly payment would be around $1,799. But by refinancing to a new, 30-year loan after just two years of making payments, your monthly payment would decrease to $1,755. And if refinancing also meant lowering your interest rate (say from 6% to 5.5%), your payment drops even lower to $1,662 per month.
If you purchased your home with an adjustable-rate mortgage – a home loan that starts with an interest rate that is fixed for an introductory period, then fluctuates with market rates – refinancing to a fixed-rate mortgage could mean more predictable monthly payments because your interest rate will stay the same for the lifetime of the loan.
Steady monthly payments can be helpful for budgeting and planning purposes, so although fluctuating property tax and insurance costs will still mean some room for variation each month, having a better idea of what you’ll have to pay can provide some welcome peace of mind.
Depending on the size of your down payment and the specific loan type, you may be required to pay for mortgage insurance to secure home loan financing. With a conventional loan, private mortgage insurance (PMI) is required when you put less than 20% down. With an FHA loan, which is backed by the Federal Housing Administration, a mortgage insurance premium (MIP) is required when you put less than 10% down.
But once you reach these milestones in home equity, you can refinance your loan to remove the mortgage insurance requirement. And because mortgage insurance is charged as part of your mortgage payment, avoiding it means lower payments every month.
If you’re in need of extra funds for things like home improvements, renovations or debt consolidation, tapping into your home equity may be a great option. A cash-out refinance allows you to borrow against the equity in your home by refinancing your original mortgage into a new loan with a higher loan value.
For example, let’s say you’ve paid off $100,000 of your $300,000 home – meaning you still owe $200,000. With a cash-out refinance, you can increase this total balance to cash out some of the equity as a lump sum. So, if you choose to cash-out $30,000 in home equity, your new loan amount would be equal to $230,000.
For all the potential upsides of a refinance, there are just as many downsides that must be considered. Each refinance is unique to the individual situation, so what may be right for one family may not be for the next.
To ensure you’re making the best choice for your financial future, consider the following factors.
Keep in mind that refinancing will mean originating a new loan, so you’ll be responsible for paying closing costs, which typically cost 3% – 6% of the total loan amount. This is an important consideration to make ahead of time as these costs can diminish the potential savings of your refinance, especially if you aren’t prepared for them.
Of course, the savings in interest over the lifetime of the loan should well exceed the costs due at closing, but this brings up the debate of short-term cost vs. long-term savings. Though the long-term benefits may be appealing, a refinance only makes sense for homeowners who can afford the upfront costs without breaking the bank.
With the upfront costs in mind, how do you know if the savings of a refinance are worth the expense?
Whether you’re looking to obtain a lower monthly payment or save money on interest over the lifetime of the loan, you’ll have to do a bit of math to determine if a refinance is right for you. You can also leverage a refinance calculator to simplify these calculations.
When you run the numbers to determine the potential savings of a refinance, you’ll need to weigh all the potential benefits and drawbacks to make the best choice.
Depending on the interest rate of the original loan, current mortgage rates and the borrower’s credit score, savings could end up being minimal and may not be worth the time and energy it takes for some homeowners.
Although refinancing has the potential to decrease your monthly mortgage payment, it also has the potential to increase it. If your goal is to pay off your home loan faster, refinancing from a 30-year mortgage to a 15-year mortgage may be a good option – but keep in mind that this will also mean paying more each month.
Let’s circle back to our trusted example scenario. After 2 years of payments, you’ve lowered your total loan balance from $300,000 to $288,750 and decide to refinance. With interest rates staying the same at 4%, you decide to shorten your loan term, which will save you money in total interest paid. However, despite the long-term savings, this would mean increasing your monthly mortgage payment from $1,433 per month on the original loan to $2,136 per month on the refinanced loan.
Your home’s equity is a valuable resource but tapping into it isn’t without its risks. By taking out some of the equity in your home through a cash-out refinance, you’re effectively taking on additional debt secured by your home.
This type of refinance will likely mean increasing your mortgage payments, so it’s important to make sure you can afford an additional monthly expense before moving forward.
As we mentioned earlier, refinancing for the same term or a longer loan term will mean restarting the life of the loan. This means extending the period of time you have to make payments, which in turn usually leads to a lower monthly cost.
However, this will also mean paying more in interest over the loan’s lifetime, so it’s crucial to weigh the short-term savings alongside the long-term costs.
If refinancing doesn’t make sense for your situation, don’t worry – there are other options to consider if you’re in need of fast cash or looking to save money on your mortgage payments. Here are a few of your options:
Should you refinance your home loan? The answer to this question can be complicated and depends heavily on the specific details of your situation, including your original loan terms and your long-term financial goals. Be sure to consider all the potential advantages, disadvantages and alternatives before choosing the loan option that is right for you.
If you’re ready to take the next step, start the mortgage application process to determine what you qualify for and obtain more information about your refinance options.
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An FHA cash-out refinance allows homeowners to refinance their mortgage and take out a lump sum payment of cash. Learn more about FHA cash-out refinances here.
How do you get a home improvement loan? Read our guide to learn what a home improvement loan is and what the best options are to cover your renovation project.