Pondering a mortgage refinance? There’s much to consider before pulling the trigger on this significant financial decision. Namely, how would a refi benefit you? What are the pros and cons of refinancing your home? Do the benefits of refinancing your home outweigh any disadvantages? And what refinancing alternatives exist?
Trust this handy guide to help you navigate the plusses and minuses of a refi.
Key Takeaways
- Refinancing can be beneficial for reducing monthly payments, shortening or extending loan terms, or tapping into home equity, but only if it makes good financial sense.
- Refinancing also has potential downsides that may offset the advantages, such as upfront fees, increased total costs if extending the loan term, and additional paperwork.
- Alternatives to refinancing include pursuing a HELOC, home equity loan, mortgage recasting, or loan modification, each offering different ways to manage costs without a full refinance.
- Carefully weigh the pros and cons of refinancing to ensure they align with your financial goals, and work with an experienced lending expert who can help you make an informed choice.
Pros of Refinancing
It doesn’t make much sense to refinance your mortgage loan unless you stand to benefit in some way – usually by improving your financial position via more affordable payments, a quicker payoff, or the ability to liquidate home equity. Here’s a roundup of the most common advantages a refinance provides borrowers.
Save Money in the Short Term
“Refinancing to a lower interest rate can reduce monthly payments, providing immediate savings that improve cash flow,” says Carl Holman with A&D Mortgage. “This is particularly helpful if you are facing other financial challenges, as it allows you to allocate funds toward other expenses or savings. Lower monthly payments can create breathing room in your budget without needing to compromise on other financial goals.”
Additionally, if you must pay private mortgage insurance (PMI) because you put down less than 20% on your home but have since raised your equity position past 20%, refinancing can eliminate PMI, lowering monthly mortgage payments.
Note: Refinancing isn’t required to cancel PMI on a conventional mortgage. Learn how and when to cancel PMI here.
Or, even if you don’t lower your interest rate or eliminate PMI through refinancing, you can create more affordable monthly payments by extending your loan term. Imagine you have a mortgage with a 7.0% fixed interest rate, a remaining balance of $250,000, and 27 years left on the term. If you refinance to a new loan with a 6.0% fixed interest rate and a 30-year term, you’ll extend the repayment period by three years, but your monthly payment will decrease from $1,663 to around $1,450, saving you more than $213 per month (although you’ll likely pay $3,000 or more in closing costs by refinancing in this scenario).
Save Money in the Long Term
Refinancing to a lower interest rate or a shorter loan term can significantly reduce the total interest paid over the life of the loan. A rate reduction of just one percentage point (100 basis points) could save you tens of thousands of dollars on a 30-year mortgage. Choosing a shorter term, like a 15-year mortgage, can also help you build equity more quickly, reduce interest payments, and pay off your home sooner.
For instance, using the previous example, if you refinance your $250,000 loan at 7.0% interest with 27 years remaining to a 15-year loan at a 6.0% fixed rate, your monthly payment would rise to about $2,041, compared to $1,663 before. However, you would reduce your loan term by 12 years and save a total of $171,588 in interest over the life of the loan.
Let our refinance calculator do the heavy math.
Access Equity to Pay Off Big Expenses or Improve Your Home
“A cash-out refinance enables homeowners to replace their existing mortgage with a new one and take out equity in their property in the form of cash at closing,” says Sean Grzebin, chief executive officer of Home Lending at JPMorgan Chase. “Cash-out refinances allow homeowners to use the equity in their homes to help fund the things they can’t, like medical expenses, home improvements, debt consolidation, and other big purchases.”
This option often offers lower rates than credit cards or personal loans, and any improvements made to your home could increase its value, potentially improving your return on investment if you sell.
“Keep in mind that cash-out refinances may require a slightly higher interest rate – often one-eighth to one-quarter of a percentage point higher – than standard refinances,” Grzebin adds.
Pay Off Your Loan Faster
Refinancing to a shorter loan term, like a 15-year mortgage, allows you to pay off your loan faster (as demonstrated in the earlier example). Although this increases monthly payments, it reduces the total interest paid over the loan’s life and accelerates equity buildup. This strategy is good if you want to reduce debt and own your home outright sooner.
Another way to accelerate your mortgage debt repayment is to opt for a “cash-in” refinance, where you refinance your mortgage and contribute a lump sum payment toward the principal balance, lowering the amount you need to borrow. This reduction in loan size can help you secure a lower interest rate or better loan terms. Additionally, paying down the balance may help you avoid paying private mortgage insurance (PMI) if your loan-to-value (LTV) ratio drops below 80%.
More Predictable Monthly Payments
Got an adjustable-rate mortgage (ARM) but want more predictable payments? Refinance that ARM to a new fixed-rate mortgage loan.
“This can be especially beneficial if you expect interest rates to rise in the future, as a fixed-rate loan locks in your rate and protects you from potential increases, giving you peace of mind with consistent budgeting,” continues Holman.
Adjust Terms to Accommodate Life Changes
Refinancing allows you to adjust the terms of your loan to suit changes in life, such as a new job, marriage, divorce, or retirement. If your income decreases, extending the loan term can reduce monthly payments. Conversely, if your income increases, refinancing to a shorter term can help you pay off your mortgage faster. This flexibility makes refinancing a valuable option for adapting your mortgage to your current financial situation.
Cons of Refinancing
As with any financial decision, you shouldn’t overlook the tradeoffs and potential disadvantages of committing to a mortgage refinance.
It Takes Time to Recoup the Initial Costs
Refinancing involves upfront costs like closing fees, appraisal charges, and lender fees, typically totaling 2-5% of the loan amount. Depending on how much you save each month, recouping these costs can take several years. Case in point: if your closing costs are $5,000 and you save $200 per month, it will take 25 months to break even. Be sure to consider how long you plan to stay in your home before refinancing.
“Refinancing always comes with a cost, so it’s important to weigh your monthly savings against other factors – including how long you plan to stay in your home,” says Beverly Hankinson, senior vice president and mortgage loan advisor manager for Frost Bank. “For example, if you plan to move for more space in the next two to three years, it might not make sense to refinance now and pay those closing costs that you likely won’t recoup.”
Use our refinance break-even calculator to model your personal scenario.
Extending Your Loan Term Could Increase Long-Term Costs
Lengthening your mortgage term to reduce monthly payments can increase the total cost of your loan in the long run. If you refinance a 30-year loan after five years, you might end up paying interest for an additional five years, increasing the overall loan cost. Weigh the immediate benefit of lower monthly payments against the long-term impact of more interest payments.
Decreasing Your Loan Term Could Increase Monthly Payments
“While refinancing to a shorter term, such as from a 30-year to a 15-year mortgage, can help you pay off your loan more quickly and save on interest, it often comes with a higher monthly payment,” cautions Holman. “This can put a strain on your monthly budget, particularly if your income fluctuates or you have other financial obligations.”
The bottom line? While the benefits here likely outweigh the drawbacks, ensure you can comfortably manage the higher payments before shifting to a shorter loan term.
Taking Cash Out Could Reduce Your Equity
A cash-out refinance involves borrowing against the equity you’ve built in your home, which reduces your ownership stake. While this can provide cash for urgent expenses or investments, it means owing more on your mortgage and having less equity as a cushion. If home values drop, you could owe more than your home is worth, which is risky if you need to sell or refinance again.
Other Possible Drawbacks
Refinancing has some other potential disadvantages to consider, too.
“There is the risk of resetting your mortgage clock, which means you’ll start from scratch on a new repayment term – delaying your goal of fully owning your home,” Holman warns.
Also, if you refinance and borrow more than 80% of your home’s value, you may be required to pay for private mortgage insurance (PMI), which could offset any savings you gain.
“Plus, refinancing can involve a significant amount of paperwork and time, which may be burdensome if you are busy or navigating other life changes,” adds Holman.
Another reason for avoiding a refi is that it requires a hard pull of your credit.
“This can cause your credit score to dip, though it may only be temporary. But, that dip in your score can be something you really want to avoid if there are other reasons in the near future where a good score is necessary, like if you are in the market for a new car,” says Seamus Nally, CEO of TurboTenant.
Lastly, note that when you refinance a mortgage, you pay off your current loan early and replace it with a new one, which can trigger a prepayment penalty if your original loan includes this clause. This penalty, intended to help the lender recoup lost interest, is typically only applied if the loan is paid off within the first few years. The amount varies by lender and can be a percentage of the loan balance, a flat fee, or a few months of interest. However, some mortgages allow refinancing after a certain period without penalties.
Alternatives to Refinancing
Refinancing isn’t your only choice. Here are some financial alternatives to consider:
- Home equity loan: This financing option allows you to access a lump sum of your home’s equity, typically at a higher interest rate than your primary mortgage. Your existing mortgage isn’t affected, but the home equity loan gives you additional funds for major expenses.
- Home equity line of credit (HELOC): A HELOC offers flexibility by allowing you to borrow against your home’s equity as needed. You can draw from this line of credit over time, making it a convenient option for funding large costs.
- Mortgage recasting: This option enables you to reduce your monthly payments by making a lump-sum payment toward the principal. Unlike refinancing, recasting doesn’t change your loan’s interest rate or term but can offer immediate financial relief.
- Loan modification: If you’re experiencing financial difficulties, a loan modification can adjust the terms of your existing mortgage to make payments more manageable. While it may impact your credit, it doesn’t involve replacing your loan entirely.
The Pros and Cons Depend On Your Unique Situation
As with any important financial decision, it’s crucial to weigh the pluses and minuses carefully to help you determine if refinancing is worthwhile. Bear in mind that not every pro and con listed here necessarily applies to your unique situation. But in general, if the math comes out in your favor in either the long- or short-term, and you plan to remain in place long enough to garner enough loan savings to cover the closing costs, a refinance could make perfect sense.
Still in doubt? Talk with a trusted lending professional who can help you make a more informed decision about refinancing.
