- Refinancing your mortgage could be a good way to get a lower rate and monthly payment.
- You’ll need to pay closing costs again, though, which will come to thousands of dollars.
- You may decide taking out a second mortgage or personal loan is a better fit than refinancing.
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When you refinance your mortgage, you replace your existing mortgage with a brand-new one. This new mortgage comes with a different interest rate, monthly payment, and term length.
Refinancing can be a great way to save money on your mortgage, but it isn’t for everyone. The pros and cons will depend on the terms of your new mortgage. For example, if you refinance into a longer term — say, from a 20-year mortgage into a 30-year mortgage — lower monthly payments will be a major upside. But the tradeoff will be paying more in interest in the long run.
Consider the following pros and cons before deciding whether to refinance your mortgage:
Lock in a better interest rate
Mortgage rates are at historic lows right now, so it could be a good idea to refinance into a mortgage with a better rate.
This is especially useful if the new rate would be significantly lower. If you bought your home last year, the refinanced rate might not be low enough to entice you to go through the refinancing process. But if you got your initial mortgage a decade ago, you may find that a new rate would be low enough to save you tens of thousands of dollars.
Lower your monthly payments
When you refinance into a new rate, you could potentially lower your monthly payments, too.
Let’s say you have 15 years left on your initial mortgage, and you refinance for a lower rate into a 15-year term. Your payment will probably go down. If you refinance into a 20-year term, you’ll save even more every month because you’re spreading the same loan principal out over a longer period of time.
Keep in mind, if you stretch your mortgage out across a longer term, you’ll be paying your mortgage for longer. But depending on your goals, you may decide it’s worth it.
Pay off your home sooner
Maybe your original mortgage term was 30 years, and you have 20 years left on your mortgage. If you refinance into a 15-year mortgage, you would pay off your mortgage five years earlier.
Refinancing into a shorter term saves you thousands of dollars. Not only are rates at historic lows right now, but lenders charge lower rates on shorter terms. Plus, if you get a term that’s five years shorter, that’s five years that you won’t have to pay interest.
Tap into your home equity
If you’ve gained equity in your home since buying it, you may decide to apply for a special type of refinance: a cash-out refinance.
With a cash-out refinance, you take out a mortgage for more than the amount you still owe so you can use your home’s equity for other purposes, such as paying off debt or making home improvements.
The amount you’re allowed to receive in cash may depend on your lender, but as a general rule of thumb, you can’t receive more than 80% of your home’s value in cash. This way, you keep at least 20% of your equity in the home.
A cash-out refinance gives you the opportunity to accomplish other financial goals, and there are no limits as to how you can spend the money.
Get rid of private mortgage insurance
You’re likely making monthly payments toward private mortgage insurance if you had less than 20% for a down payment when you bought the house. You can ask your lender to cancel PMI once you reach 20% equity in your home, but they aren’t guaranteed to approve your request. The lender will automatically cancel PMI once you have 22% equity in your home.
But if it’s still going to be a while before you reach 20% or 22% equity in the home, you may be able to refinance to cancel PMI. If your refinanced mortgage is for less than 80% of your home value, then you wouldn’t need PMI on the new loan. By getting rid of PMI, you’ll lower your monthly payments.
Pay closing costs
Just as with your original mortgage, you’ll have to pay closing costs when you refinance. Closing costs include everything from legal fees, to an appraisal, to a loan origination fee.
According to the Federal Reserve, closing costs typically cost 3% to 6% of your outstanding mortgage principal. So if you have $100,000 left to pay on your mortgage when you refinance, you’ll pay $3,000 to $6,000 in closing costs.
Some lenders will advertise “no closing cost” refinancing, but you’ll still pay these expenses over time. Instead of paying them at closing, you’ll either face a higher interest rate or pay a little extra each month to make up the difference.
Monthly payments could be higher
Refinancing into a shorter-term mortgage is a great way to pay off your loan sooner. Just know that by doing so, your monthly payments will be higher.
If you have 20 years left on your mortgage and refinance into a 15-year term, for example, you’re cramming the same loan principal into a shorter period of time. So you have to pay more each month to pay off the same amount faster.
But your monthly payments might not go up if you refinance into either the same term length or a longer term length.
Increasing your term length will cost you
Maybe you have 20 years left on your mortgage but refinance into a 30-year mortgage. Now you have 10 more years to pay off your loan, and your monthly payments will be lower.
This is an expensive route to take, though. Adding 10 years to your mortgage means you’ll pay interest for 10 more years, which will likely cost you tens of thousands of dollars in the long run.
You may still decide refinancing into a longer term is worth the cost. Just be aware of what you’re getting into.
Refinancing might be the best decision for you, or you may decide it’s not quite the right fit. Here are some other types of loans you may consider, depending on your goals:
Apply for a home equity loan
With a home equity loan, you receive cash in one lump sum. Then you pay it back in monthly installments over a predetermined amount of time, like 30 years. It’s a similar concept as a regular mortgage, except it provides you with cash. And like a cash-out refinance, it lets you borrow against the equity you have in your home.
The main difference between a home equity loan and a cash-out refinance is that the former is a second mortgage. A cash-out refinance replaces your initial mortgage, but a home equity loan adds a second mortgage payment to your monthly expenses.
Interest rates are higher on a home equity loan than a cash-out refinance, but closing costs are usually lower.
Apply for a home equity line of credit
A HELOC is another type of second mortgage, and it works more like a credit card than like a regular mortgage. The lender gives you a borrowing limit, and you can borrow from that line of credit as needed. Maybe you take out $5,000 to pay off a credit card, then $10,000 later to remodel your bathroom.
As with a credit card, you’ll pay back what you borrow, and you can borrow more later. If your borrowing limit is $20,000 and you borrow $10,000, you have $10,000 left to borrow. But if you pay back the full $10,000, your limit is back to $20,000.
Your lender gives you a “draw period,” which is a chunk of time you’re allowed to borrow money — usually 10 years or less. At the end of the draw period, you must repay any balance you haven’t paid back yet.
You might like a HELOC if you’ve gained equity in your home and want to borrow money as needed, but the rate is typically higher than what you’ll pay with a cash-out refinance.
Take out a personal loan
You may prefer a personal loan over a refinanced mortgage. The application and approval process is quicker, and you’ll pay back the loan over a shorter amount of time than a mortgage.
However, personal loan rates are often higher than mortgage rates. And with such low mortgage rates these days, it could be a good time to refinance.
Laura Grace Tarpley is the associate editor of banking and mortgages at Personal Finance Insider, covering mortgages, refinancing, bank accounts, and bank reviews. She is also a Certified Educator in Personal Finance (CEPF). Over her four years of covering personal finance, she has written extensively about ways to save, invest, and navigate loans.