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Mortgage rates have trended upward since the beginning of the year — and while they retreated a bit in late 2022, they still are higher than they’ve been in 20 years. Nevertheless, it might be worth refinancing your mortgage to save on monthly payments or to get some extra cash.
As you assess your situation, here are the best (and worst) reasons to refinance.
Why consider a mortgage refinance?
Refinancing your mortgage means replacing your old loan with a new one. You apply for a new mortgage against your home and pay off the remaining balance of your existing loan.
This gives you the opportunity to adjust the term of your loan, change the interest rate, or pull equity out of your home as cash that you can use for other purposes.
For example, you might consider refinancing your loan to swap from an adjustable-rate loan to a fixed-rate one or to lower your monthly payment.
Best reasons to refinance your mortgage
There are many reasons you might consider refinancing your mortgage. You can use the equity in your home for other purposes or adjust the details of your loan.
Some of the best reasons to refinancing include:
- Lower your interest rate
- Consolidate high-interest rate debt
- Tap into your home equity for cash
- Eliminate mortgage insurance
Lower your interest rate
Known as a “rate-and-term” refinance, this is the most popular reason borrowers refinance. Borrowers with a higher interest rate on their current loan could benefit from a refinance if the math pans out — especially if they’re shortening their loan term.
Shorter-term mortgages typically have lower interest rates than longer-term mortgages because you’re paying back the loan in less time, but your monthly payment will likely go up.
A rate-and-term refinance can result in big savings for a homeowner if there’s room in their budget for it, says Kurt Johnson, chief risk officer with mortgage lender Mr. Cooper.
“If you can afford to shorten the term of the loan and you are substantially lowering your rate, it could be a win-win as you’re paying off your mortgage faster and saving a ton of money on interest,” Johnson says.
Right now, however, interest rates are rising, reflecting the Federal Reserve’s efforts to contain inflation. But there’s still opportunity. You could still come out ahead if your current rate is higher than what’s prevailing today.
Consolidate high-interest debt
If you have a hefty amount of high-interest debt on credit cards, car loans or personal loans, a cash-out refinance can help improve your cash flow and save you money in the long term, possibly even if you take a slightly higher mortgage rate.
“There’s this myth that in order for a refi to make sense that you have to lower the rate by 1 percent or more, but I disagree,” says Elizabeth Rose, a certified mortgage planning specialist based in Texas. “Even with losing some mortgage interest deductibility, in the long run, it’s improving your cash-flow situation, saving you money and getting you out from underneath your debt quicker.”
The drawback to this move is that you’ll be unable to deduct the mortgage interest you pay on the cash-out amount that exceeds the current loan balance if the funds aren’t used to “buy, build or substantially improve” your home, according to the IRS.
Another consideration is that you’re securing unsecured credit card debt with your home. Be careful as you move forward, and make sure you can afford your new terms to reduce the risk of losing your home.
Tap into your home equity for cash
Tapping home equity to pay off high interest debt is one thing you can do when refinancing, but you can also use cash-out refinancing for other purposes.
For example, using home equity to pay for home improvement or an expansion lets you avoid signing up for a personal loan at a higher interest rate and adding another monthly payment to your list of bills.
You might also use the equity to do something like pay for your child’s college tuition. However, federal student loans also carry favorable rates and terms, so it might be wiser to let your child borrow rather than doing so through a refinance.
Eliminate mortgage insurance
This is especially true if you have a loan insured by the Federal Housing Administration (FHA). While FHA loans can be a viable path to homeownership for borrowers with little savings or not-so-stellar credit, they come with a big downside: mandatory mortgage insurance. After paying an upfront premium of 1.75 percent of the loan amount, most FHA borrowers continue to pay an annual mortgage insurance premium of 0.85 percent of the loan amount for the remainder of the 30-year term that cannot be canceled. That adds up over time.
To eliminate PMI, homeowners can refinance an FHA loan into a conventional mortgage once they gain 20 percent equity in their home.
Worst reasons to refinance a mortgage
Refinancing a mortgage isn’t always a good idea. If you refinance for one of these reasons, it could negatively impact your finances in the long run:
- Save money for a new home
- Splurge on luxury purchases
- Move into a longer-term loan
- Pay off your home faster if you haven’t met other financial goals
- You recently bought your home
Save money for a new home
Refinancing isn’t free; you’ll pay roughly 2 percent of the loan amount or more in closing costs, and it can take a few years to break even. Moving up to another home before you’ve recouped those costs means you’ll probably lose money even if you manage to lower your monthly payments in the interim.
“If a homeowner is planning to move within the next five years, they may not get as much benefit from a refinance,” Snyder says. “Often, the costs [of a refinance] could outweigh the benefits.”
A refinance break-even calculator can help you decide how long you should stay in your home after a refinance to recoup the costs.
Splurge on luxury purchases
Tapping your home equity like an ATM to misuse it without a clear financial goal in mind is dangerous, Rose cautions. Using a cash-out refinance to pay for a new car or RV, invest in speculative assets or to splurge on luxuries or a lavish vacation can lead to even more financial turmoil, she says.
In many ways, it’s no different from using a credit card or personal loan for a splurge purchase. You’re taking on a liability (additional home debt) without reducing the cost of your liabilities (lower rates on other debt) or adding value to your assets.
While it might be tempting to get the money at a low rate, remember that you’re securing these purchases with your home. If you run into trouble later, you’ll have less equity to tap and depreciating assets that can drag you down.
“There has to be some sort of net tangible benefit to the homeowner to refinance,” Rose says. “I don’t recommend cash-out refinancing for anything that won’t add security to or improve your financial picture.”
Move into a longer-term loan
Snagging a lower rate and lowering your payments might seem like a great move, but refinancing when you’re already halfway or more through a 30-year mortgage is rarely a good idea, says Steven Jon Kaplan, CEO of True Contrarian Investments in New York City.
“Before you refinance, the most important consideration is how much interest is being paid throughout the remainder of the loan, and how long the loan will continue,” Kaplan says. “When you’re in the final half of a mortgage, such as the final 15 years of a 30-year mortgage, it’s a very bad idea to refinance because you are finally at a point where you are paying back more principal than interest. When you refinance, the amortization begins from scratch so you will waste the first decade or so paying off almost all interest.”
This strategy can make sense in one situation: If you’re retired and on a fixed income and need a lower monthly payment to be able to better manage your cash flow.
Pay off your home faster if you haven’t met other financial goals
Refinancing into a shorter-term loan solely to pay off your loan faster can short-change you on other financial goals. More of your money will be tied up in your house that could be put toward increasing your retirement account contributions, college fund savings, paying down debt or making investments with higher returns.
After you’ve checked off those boxes and if the spread between your current interest rate and a shorter-term refinance rate isn’t that large, consider knocking down your mortgage debt another way, recommends Johnson, the Mr. Cooper lending executive.
“You can always pay more principal on your existing mortgage to pay it off in 15 years while giving yourself the option of making smaller payments if you are faced with financial hardship [in the meantime],” Johnson says.
You recently bought your home
Even if rates dip slightly within the first year of your home purchase, refinancing into another mortgage too soon isn’t advisable, Johnson says.
“This is lender churning, which is usually beneficial for the lender but, when refinance costs are considered, rarely benefits the customer,” Johnson says.
Bottom line on reasons to refinance your mortgage
Refinancing your mortgage can help make your mortgage payment more affordable or get you cash to meet other financial goals. Before you move forward, however, evaluate your motivation to refinance — there are both good and not-so-good reasons to do it — and weigh the costs and benefits.