When to Refinance Your Mortgage

Refinancing a mortgage means paying off an existing loan and replacing it with a new one. There are many reasons why homeowners refinance:

To obtain a lower interest rate

To shorten the term of their mortgage

To convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, or vice versa

To tap into home equity to raise funds to deal with a financial emergency, finance a large purchase, or consolidate debt

Since refinancing can cost between 3% and 6% of a loan's principal and—as with an original mortgage—requires an appraisal, title search, and application fees, it's important for a homeowner to determine whether refinancing is a wise financial decision.

KEY TAKEAWAYS

Getting a mortgage with a lower interest rate is one of the best reasons to refinance.

When interest rates drop, consider refinancing to shorten the term of your mortgage and pay significantly less in interest payments.

Switching to a fixed-rate mortgage—or to an adjustable-rate one—can make sense depending on the rates and how long you plan to remain in your current home.

Tapping equity or consolidating debt are other reasons to refinance—but beware, doing so can sometimes worsen debt problems.

Refinancing to Secure a Lower Interest Rate

One of the best reasons to refinance is to lower the interest rate on your existing loan. Historically, the rule of thumb is that refinancing is a good idea if you can reduce your interest rate by at least 2%. However, many lenders say 1% savings is enough of an incentive to refinance.  Using a mortgage calculator is a good resource to budget some of the costs. 

Refinancing to Shorten the Loan's Term

When interest rates fall, homeowners sometimes have the opportunity to refinance an existing loan for another loan that, without much change in the monthly payment, has a significantly shorter term.


For a 30-year fixed-rate mortgage on a $100,000 home, refinancing from 9% to 5.5% can cut the term in half to 15 years with only a slight change in the monthly payment from $805 to $817. However, if you're already at 5.5% for 30 years ($568), getting, a 3.5% mortgage for 15 years would raise your payment to $715. So do the math and see what works.


Refinancing to Convert to an ARM or Fixed-Rate Mortgage

While ARMs often start out offering lower rates than fixed-rate mortgages, periodic adjustments can result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to fixed-rate mortgage results in a lower interest rate and eliminates concern over future interest rate hikes.


Conversely, converting from a fixed-rate loan to an ARM—which often has a lower monthly payment than a fixed-term mortgage—can be a sound financial strategy if interest rates are falling, especially for homeowners who do not play to stay in their homes for more than a few years.


These homeowners can reduce their loan's interest rate and monthly payment, but they will not have to worry about how higher rates go 30 years in the future.


If rates continue to fall, the periodic rate adjustments on an ARM result in decreasing rates and smaller monthly mortgage payments eliminating the need to refinance every time rates drop. When mortgage interest rates rise, on the other hand, this would be an unwise strategy.


Refinancing to Tap Equity or Consolidate Debt

While the previously mentioned reasons to refinance are all financially sound, mortgage refinancing can be a slippery slope to never-ending debt.


Homeowners often access the equity in their homes to cover major expenses, such as the costs of home remodeling or a child's college education. These homeowners may justify the refinancing by the fact that remodeling adds value to the home or that the interest rate on the mortgage loan is less than the rate on money borrowed from another source.


Another justification is that the interest on mortgages is tax-deductible.1 While these arguments may be true, increasing the number of years that you owe on your mortgage is rarely a smart financial decision nor is spending a dollar on interest to get a 30-cent tax deduction. Also note that since the Tax Cut and Jobs Act went into effect, the size of the loan on which you can deduct interest has dropped from $1 million to $750,000 if you bought your house after Dec. 15, 2017.2


Many homeowners refinance to consolidate their debt. At face value, replacing high-interest debt with a low-interest mortgage is a good idea. Unfortunately, refinancing does not bring automatic financial prudence. Take this step only if you are convinced you can resist the temptation to spend once the refinancing relieves you from debt.

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