Taking out a mortgage typically means making regular payments until the loan is paid off. But while this may have been the traditional way of looking at mortgages, many homeowners these days are choosing to keep their mortgages by refinancing to take advantage of certain benefits, such as getting a lower interest rate, using the equity to invest, consolidating debt, or taking advantage of tax deductions.
Refinancing a mortgage basically means paying off an existing loan and taking out a new one. Considering the low mortgage rate environment we’ve been in for a while now, some might question whether it makes more sense to keep refinancing instead of just paying off the mortgage and getting rid of it once and for all.
The strategy of refinancing a mortgage to a new 30-year loan every decade or so typically involves using the equity and cash savings to put towards higher-return investments or paying off higher-interest debt.
The question is, should you pay your mortgage off and relieve yourself of regular principal-plus-interest payments? Or should you keep refinancing to open up capital to be used for other financial reasons? The answer to that will depend on your specific situation.
What Are the Benefits of Refinancing?
The advantages of paying off your mortgage sooner rather than later are obvious: it’s one massive debt that you can scrap off the books. No more managing payments and making sure there’s enough money in the pot to make sure payments are made on time and in full every month. Instead, that money can be freed up to do with as you please.
But there are real benefits to refinancing, or else homeowners wouldn’t consider it at all.
The number one reason that many homeowners refinance their mortgages is to take advantage of a lower interest rate. Some even go so far as to buy points to reduce this rate. And the reason is obvious: the lower the rate, the more money is put towards the principal. Translation? The overall cost of the home can be drastically reduced.
Refinancing also allows for extra money from equity to be freed up in the budget to be put towards both short- and long-term savings goals.
Consider Refinancing Only if You’ve Got Plenty of Equity Built Up
If you’ve been making regular payments for a few years now, and property values in your area have been steadily increasing, you could potentially have quite a handsome amount of equity built up in your home. This is a crucial factor, since refinancing is typically possible only if you have home equity. Not only that, but you usually need a minimum of 20% in home equity if you want to avoid having to pay Private Mortgage Insurance (PMI).
The only way to know exactly how much equity you have in your home is to have it appraised, then deduct the amount that you still owe on your mortgage.
Consider the Costs Associated With Refinancing
Taking advantage of low interest rates is great, but don’t assume that you’ll necessarily be saving a ton of money; you’ll need to figure out all the upfront costs of refinancing before you decide whether or not it makes financial sense for you. You’ll be responsible for covering fees related to the following:
Applications ($100 – $300)
Loan originations (up to 1.5% of the principal)
Appraisals ($300 – $800)
Inspections ($200 – $350)
Attorney reviews ($500 – $1,000)
Title searches and insurance ($700 – $1000)
Surveys (approximately $400)
Prepayment penalties
Generally speaking, refinancing costs about 1 to 2 percent of the entire loan value. Of course, locking in a really low rate can justify these costs as long as all the other numbers associated with your unique financial position support the move.
How Do You Plan on Using the Extra Money Freed Up From a Refinance?
If you want to free up some cash from the equity in your home via refinancing, you can do so in a couple of ways.
One way would be to lower your monthly payments because of a reduced interest rate or an extension of the loan term. The other way is with a cash-out refinance whereby the lender provides you with a lump sum of money.
Let’s say your home is worth $400,000, and you currently have a $200,000 loan outstanding on it. If you refinance with a new loan for $300,000, that fees up $100K since you only needed $200K to pay off your old mortgage.
Of course, that $100K isn’t exactly free, per se; it’s still subject to the interest rate that your mortgage is attached to.
Once you’ve tapped into the equity through a refinancing program, there are a number of things you can do with the cash.
Consolidating debt – Maybe you’ve got a bunch of high-interest debt on the books that you’re finding tough to get rid of. By refinancing at a much lower interest rate, you can pay off these debts, such as credit cards, and potentially save a lot of money in interest.
If you’re consistently falling behind on your credit card payments, your debt will continue to mount, and your credit score can suffer. In that case, using your home equity to pay off this debt might make sense. But you need to be 100% certain that you’ll be able to afford your new mortgage payments in favor of a refinance, or your could lose your collateral – your home.
Making profitable investments – If you’ve dreamed of investing your money as a way to build wealth and pad your retirement nest egg, but never had enough available liquid cash to do so, a refinancing program can be the ticket to feeing up some capital.
This can work to well if your investments are projected to pay out more than what you’re currently paying in interest to hold your mortgage. Ideally, the investments you make should also have a proven historical track record of performing well.
But you’ve got to weigh the risks associated with making certain investments, and understand the potential of being stuck with even more mortgage debt. The important thing to remember is that you need to make absolutely sure that you can afford your mortgage payments, no matter how well – or poorly – your investments do.
Paying for college tuition – Getting a post-secondary education these days is downright expensive. If you’ve got a child at home who’s embarking on a college career, you’re going to need to flip the bill somehow. And if you haven’t been saving for it up until now, you’ll need to come up with another way to finance the tuition; perhaps through refinancing your mortgage.
A situation like this might not actually have as much of a benefit considering student loans usually have low interest rates (though not necessarily as low as mortgage rates). On the other hand, refinancing could lower the risk of default if you lower your mortgage payments.
So, is refinancing a good idea?
It’s a loaded question, and one that requires a deeper look at your short- and long-term financial goals, your current state of finances, the equity you’ve already built up in your home, and why you’d want to free up the equity in the first place. Before you make a move, be sure to speak with a financial advisor and mortgage specialist to make sure refinancing is right for you.
