Pros and Cons of Refinancing Your Home

Pros of Refinancing Your Home

There are many reasons why a mortgage refinance could be on your mind, especially when interest rates are increasing and you'd like to lock in a low fixed rate before they rise further. While rates are going up this year, you may still be able to save money if your current rate is high. But the advantages of refinancing go beyond the potential savings. Consider these pros:

Potentially Lower Interest Rate and Monthly Payment

One of the most common reasons to refinance is to get a lower interest rate. That may happen if your credit has improved since you first applied for a mortgage or if lenders are currently offering low rates due to market conditions. Refinancing can lead to big savings, especially if you also shorten your repayment timeline. You could also decide to refinance in order to opt for a lower monthly payment by choosing a longer repayment term.

If your credit is on the lower side—typically below 620 on an 850-point scale—refinancing isn't out of the question. The Federal Housing Administration (FHA), Veterans Administration (VA) and U.S. Department of Agriculture (USDA) all have programs that cater to borrowers in your situation.

Ability to Get Rid of Private Mortgage Insurance

When you get a conventional home loan and put down less than 20% of the home's value, you'll likely have to carry private mortgage insurance (PMI) to protect the lender from the risk you'll miss payments. PMI can add hundreds of dollars to your monthly mortgage costs.

But if your home's value has gone up, and you've perhaps also paid down part of your loan balance, you may now hold at least the 20% equity you need to avoid PMI. That means you can refinance to a new loan, using the new value of your home to make the equity calculation, and get rid of PMI. That will save you 0.2% to 2%, or more, of the loan balance per year.

Option to Change Loan Features

You can save money by refinancing to a shorter loan term or get a lower monthly payment by refinancing to a longer loan term. You could also switch from an adjustable-rate mortgage to a fixed rate, which is particularly attractive in a market in which rates are expected to increase.

You Can Add or Remove a Co-Borrower or Cosigner

If you first applied for a mortgage with a cosigner or co-borrower, such as a former spouse, you can refinance to a new loan and remove that individual. Or, if you'd like to add a new co-borrower―perhaps a new spouse with a very strong credit and income profile, who can help you qualify for the very best rates and terms—you can add them to the new loan.

Option to Cash Out Part of Your Equity

A cash-out refinance lets you take out a new, larger loan and take the difference between your prior and new loans in cash. That can be helpful if you're looking to pay off high-interest debt, like credit card debt, or fund a child's college education. You'll need to have equity in your home in order to qualify, and a cash-out refinance is a good idea only when you'll receive a lower rate than before as a result of the refinance.

Cons of Refinancing Your Home

A mortgage refinance isn't a no-brainer. There are still some downsides, starting with the amount it could cost. Here are the cons to be aware of:

Closing Costs

Refinancing your mortgage will come with closing costs of 2% to 6% of the new loan amount. These fees include appraisal fees, origination fees, attorney fees and more. You might be able to negotiate down some fees, and costs will likely differ depending on the lender you choose.

It's smart to compare offers from multiple refinance lenders, including the one you have your current mortgage with, to find the best terms.

Potential Negative Impact on Your Credit Score

When you apply for a refinance, the lender will conduct a hard credit inquiry in order to view your credit report, and to decide whether to work with you. A hard inquiry will stay on your credit report for two years, and could lead to a drop in your credit score that lasts a few months. Your prior mortgage will also appear as a closed account on your credit report when you refinance, which may also initially cause a drop in your score.

You won't be able to avoid this account closure or the hard inquiry when you refinance, and your credit score will probably improve as you make on-time payments toward the new loan. But keep in mind the potential effect on your credit score if you're planning to apply for another type of credit in the near future.

Potential for a Longer Loan Term or More Debt

When you refinance to a longer loan repayment period or you choose a cash-out refinance, it's important to balance the short-term benefits with the longer-term impact. Due to interest costs, you may pay more over the life of your mortgage loan if you refinance to a longer-term loan—even if your monthly payments are smaller. And if you take out a larger loan as part of a cash-out refinance, your debt-to-income ratio will rise, potentially making repayment more difficult or making it harder to borrow more in the future.

Should You Refinance Your Home?

You're in a good position to refinance your home if:

• You have good credit. Especially in a market with rising interest rates, you want to ensure you'll get the lowest possible rate and the most possible savings. Having good credit—a score of 670 or higher on the FICO scale—is your best chance at making refinancing worthwhile. If your credit has improved since you first bought your home, that's a particularly good reason to consider refinancing.
• You stand to save money. Compare your current interest rate with the refinance rate you qualify for, and the new monthly payment you'd receive. If your new rate is at least 0.5% lower, refinancing will likely net you enough savings to make it beneficial. You'll also have to save enough both per month and over time to break even on the closing costs within a reasonable amount of time.
• Changing loan attributes would improve your financial health. Refinancing is also a viable option when you want to switch to a fixed interest rate, stop paying PMI or add or remove a co-borrower. Refinancing to a longer loan term won't lead to considerable savings, but if you can afford a shorter term, such as a 15-year fixed-rate mortgage, refinancing can help you both save on interest overall and pay off your mortgage faster.

Refinancing is best avoided if:

• The interest savings aren't significant. You may find that you don't qualify for an interest rate that's much lower than what you currently have, or that your finances don't allow you to choose a shorter repayment term. That could mean that, after closing costs, refinancing won't help you save money over time.
• You're having trouble affording monthly payments. In the case of a financial hardship, refinancing to a lower monthly payment may not solve the problem, since you may not qualify for the best possible loan terms. Instead, call your loan servicer and request a mortgage modification.
• You recently bought your home and can't refinance yet. There are restrictions on how soon you can refinance certain types of mortgages. You'll have to wait at least six months before pursuing a cash-out refinance, and at least one to two years on a loan that includes hardship modifications like a lower payment or longer term.

The Bottom Line

The decision whether to refinance often comes down to the potential savings, unless you're seeking a refinance due to a specific circumstance like the desire to remove a co-borrower. The most important step, then, becomes identifying the loan options you qualify for and understanding your closing costs, interest rate, monthly payment and repayment timeline.

The way each of those factors affects your finances will be unique to you. But know that improving your credit is an empowering way to make sure you're in the best position possible to make refinancing a smart choice.