From lowering the monthly mortgage payment to cashing out on home equity, the benefits of refinancing can be a major draw for borrowers. However, what many don’t consider are the drawbacks.
If you’re not careful, refinancing could affect your finances, equity, and credit score in a negative way. That’s why it’s important to weigh the pros and cons of refinancing a mortgage. Before talking to a loan officer, homeowners should evaluate their financial position, and compare the costs and savings that may come with a new mortgage.
Here’s what you need to know about the advantages and disadvantages of refinancing:
What Is Mortgage Refinancing?
Mortgage refinancing is the process of paying off your home loan with another one. Qualified homeowners can shop around for a new mortgage that has more-favorable terms for their financial situation and goals.
The different types of refinances offer distinct benefits and may have various requirements, so it’s crucial to do enough research before refinancing.
Every homeowner’s situation is unique, and refinance benefits are ultimately determined by an individual’s finances, reasons for refinancing, and the terms of the new loan. In general, though, here are some of the typical upsides of refinancing.
Save money on interest
When market interest rates go down, many homeowners choose to refinance their mortgage to take advantage of a more competitive rate. Even with a drop of just one-half of a percentage point, qualified homeowners could put up to hundreds of dollars back in their pockets every year.
For example, if you have a 30-year mortgage for $250,000 at a 4% interest rate, your monthly payment is $1,194, and the total interest paid would be $179,674. If you refinance to a 3.5% interest rate, that same loan would have a new monthly payment of $1,123 — which is $71 less than your original payment — and the lifetime interest would amount to $154,140. That’s a savings of $25,534 in interest over the life of the loan.
Get a more desirable payment schedule
Refinancing allows you to switch up your loan’s payment schedule, which may be useful if your situation changes.
For example, if you’re feeling financially squeezed with a 15-year loan, you could refinance to a 30-year loan and reduce your monthly payments, giving you more breathing room in your budget.
Additionally, if you have an adjustable-rate mortgage and want a more consistent payment schedule — or if market rates are projected to spike — you could refinance to a fixed-rate loan for a more predictable monthly payment.
Pay off the loan sooner
A key refinancing benefit for borrowers can be reducing the amount of time spent paying off a mortgage. Shorter payment schedules, such as 15-year terms, often come with lower interest rates than 30-year loans. This could help you save on interest in the long run — though keep in mind that you’ll likely face a higher monthly payment to make up for the accelerated schedule.
If you recently received a windfall, like a bonus at work, you could choose to make a lump-sum payment with a cash-in refinance and significantly reduce the amount you owe on your mortgage. This would increase your home equity, and could also result in a smaller monthly payment, a lower interest rate, and less interest paid overall.
Access home equity
If you’ve paid down a large amount of your mortgage or your home’s value has increased since you took out the loan, a cash-out refinance could allow you to tap into that equity.
Because there are generally no restrictions on how the money from a cash-out refinance can be used, you could use the funds for immediate needs. This may include paying for emergency medical bills, a child’s college education, or renovations to improve your home’s value. The cash could also be used to pay off any high-interest debts, like credit cards.
“The benefit to getting cash-out when refinancing is that if the homeowner uses the funds to pay off high-interest debt, a homeowner could see significant interest savings and monthly payment savings,” says Khari Washington, a mortgage broker and owner of 1st United Realty & Mortgage in Riverside, California.
Although there can be many benefits to refinancing, it might not be the best option for every homeowner. Depending on your financial situation and the type of loan you have, you could face roadblocks that can complicate refinancing or make it financially inadvisable. So, before starting down this path, make sure to take a clear, hard look at your finances and weigh the cons of refinancing your mortgage.
Negative credit impact
Taking out a new mortgage closes out your original loan and decreases the overall age of your credit accounts, which causes your credit score to dip.
Additionally, when you apply for a loan, the lender will conduct a hard credit inquiry. A hard inquiry has a small, negative impact on your score, and stays on your credit report for up to two years.
However, your credit score will eventually rebound if you pay your bills on time. Also, if you submit different mortgage refinance applications within a 45-day period, the credit bureaus will typically count them as one hard inquiry, which minimizes the impact on your score.
Like your original mortgage, a refinance comes with closing costs that cover services required to approve and close the loan. These fees generally come out to an average of $5,000, according to Freddie Mac. If you spend more money on refinancing than you save, then a refinance might not be worth it.
That’s why calculating the break-even point of a refinance is important. The break-even point is your closing costs divided by your monthly savings from refinancing, and tells you how long it will take until those costs are covered.
For example, if your closing costs are $6,000 and you’ll save $50 each month by refinancing, then it would take 120 months, or 10 years, for you to break even on how much you invested in the refinance. If you sell the house or refinance again before that, then you’ll have lost money in the end.
Your original loan may come with a prepayment penalty, which could eat into your savings from the refinance. A prepayment penalty is a fee charged when you pay off a mortgage early, often within three to five years of closing on the loan.
If your mortgage includes a prepayment penalty, it must be clearly stated in your loan estimate and closing disclosure, so check there to find out whether you would need to pay that fee.
While the ability to access your equity with a cash-out refinance may be attractive, it could also hurt your ownership share. When you liquify some of your home equity, you are effectively giving up a portion of your ownership to the lender for cash. In addition, if your equity falls under 80% as a result, the lender could require you to pay for private mortgage insurance.
More interest paid with a longer term or bigger loan
Refinancing could increase how much interest you’re paying and your monthly payment, depending on how you do it.
If you refinance to a longer loan term, for example, then your monthly payment would likely decrease, but you could end up paying more interest in the long run since there’s more time for it to accumulate.
With a cash-out refinance, you’re increasing the amount being borrowed, which would likely cause your monthly payment to jump. Also, more interest can be charged on a higher loan principal.
You’re even more likely to pay more in total interest if you refinance when market interest rates are high or when your credit score has dropped.
Since mortgage refinancing is a serious decision, homeowners should carefully consider the pros and cons of refinancing a home loan before moving forward.
If you’re debating whether to refinance, here are several things you should consider:
- Are interest rates high or low right now? Interest rates have a massive impact on your monthly payment and the amount of total interest you’ll pay. If current mortgage rates are lower than the rate on your loan, then you could save money by refinancing.
- What’s your credit score? Your credit score affects not only whether you’ll get approved for a loan, but also the interest rate you’ll receive. If your score has dipped, then you might not get the best rate possible.
- Can you afford your new mortgage payment? While shortening your loan term will help you pay off your loan sooner, and having more money on hand from a cash-out refinance may be helpful, be sure to crunch the numbers to determine whether you can handle the increased monthly payment.
- How long have you had your mortgage? Some loans will require you to wait a certain amount of time before refinancing. Mortgages backed by the Federal Housing Administration, U.S. Department of Agriculture, and Veterans Affairs must be paid on time for six months or more from the starting repayment date before homeowners can refinance.
- What is the break-even point for the refinance? Even if you refinance your home at a lower interest rate, closing costs and other fees will take up some of your savings. That’s why it’s important to determine your break-even point and find out when you could start saving money.
- Are you thinking about selling your home soon? You could end up losing money from refinancing if you sell before the break-even point.
“Basically, the savings should warrant the cost, including any fees attached to the refinance,” says Andrina Valdes, chief operating officer of Cornerstone Home Lending in Houston. “Your loan officer can give you a clearer picture of potential savings based on your current financial picture and today’s market interest rate. It never hurts to ask; if you don’t like the numbers presented to you, then you can simply opt not to refinance.”
The Bottom Line on the Pros and Cons of Refinancing
Refinancing could be a great way to reduce your monthly payment and free up cash to achieve your financial goals. Before starting the process, however, you need to evaluate the pros and cons of refinancing a home loan to ensure that it’s the best choice for your situation. Refinancing, ultimately, should be a financial move that works in your favor — not against it. With the guidance of your loan officer and a thorough understanding of your finances and goals for refinancing, you can make the right decision for your lifestyle.