Refinancing is a popular option for homeowners when mortgage interest rates drop. Refinancing can be a good option for reducing your monthly payments, lengthening your mortgage or converting an adjustable rate mortgage (ARM), to a fixed rate (or in some cases, to go from a fixed to ARM), or to use the equity in your house to pay off student loans, credit card debt, or to make a purchase like a major purchase, or to take a vacation. (More about that later).
However, despite the lower interest rate being appealing at first glance, it is not as simple as it seems. Prior to making a decision, you need to consider your financial situation and what benefits you will get from refinancing.
The cost of title search, appraisal, and application fees is just one part of the overall process. This makes affordability a major concern. These are also important factors to consider before deciding whether it is time to refinance.
A majority of homeowners refinance to lower their monthly payments and their interest rates . If you can lower the rate by at least 2%, it is likely that the time has come. Even a decrease of 1% is noticeable.
You might consider a shorter term loan, such as one that is between 15 and 30 years. These cases may mean that the loan with a shorter term will cost you less each month. Our 15 or 30-year Fixed Mortgage Calculator can help calculate your monthly savings and payments.
If you have the budget to pay it, the savings you make with the lower interest rate over the term of a 15 year loan could be more than the monthly payments.
A handful of home buyers buy their home with an adjustable-rate loan. This is because ARMs usually have lower initial rates. However, adjustment periods can be harsh and it may prove costly to convert to fixed-rate loans.
Refinancing in such a scenario has two benefits: lower interest rates in short-term and greater cost certainty over the loan’s life.
If you have plans to move in the medium term (say, within five years), then it may be a good idea to convert from a fixed-rate loan to an adjustable-rate mortgage to get the lower introductory rate.
Each of these refinance situations has been financially sound so far. You can also make the next one financially sound, but you need to be aware of all the possible traps.
You might feel tempted to use your home equity to pay for unexpected expenses such as home renovations or college tuition.
These are not necessarily bad reasons to refinance. Nonetheless, relying on your home equity as a bank can lead to unexpected consequences. Think about your immediate needs and the additional years of mortgage payments (and interest) that a new loan will bring before you make a commitment to a cash-out refinance.
Consolidating high-interest credit cards and other high-interest debt with a cash-out refinance can be a sensible decision. After all, it is smart to trade several higher interest rates for one lower rate.
To make it worthwhile, however, you will need to exercise some restraint. You can not just retire your old obligations and start accumulating new credit. This will defeat your purpose.