Should I Refinance My Mortgage?

When you refinance your mortgage, you take out a new loan to repay the old one. Why would you do this?

To reduce your interest rate.
To change the mortgage term.
To remove a cosigner.
To convert to a fixed-rate mortgage from an adjustable-rate mortgage (ARM).
To cash out some of the equity you’ve built up in your house.

More folks would refinance their mortgages if it weren’t for the accompanying fees, including origination, appraisal, and title search fees. These fees, which can range in total from 3% to 6%, must play a part in a homeowner’s decision to refinance a house or leave the current mortgage in place.

Let’s review the various motivations for refinancing your house.

Reduce Your Interest Rate

Lowering your interest rate is one of the best reasons to refinance your home. After all, why pay more than you have to? When interest rates were higher, the rule of thumb was to wait on refinancing until you could lower your interest rate by 2 percentage points. In today’s low-rate environment, a 1 point reduction is easily justified.

When you simply reduce your interest rate but leave the mortgage term unchanged, you’ll decrease your monthly payment amount while accelerating the rate at which you build equity. For example, suppose 10 years ago you took a 30-year, $300,000 mortgage at 5.125%. If you were to refinance it with another 30-year mortgage, now at 3%, you would save $12,918 over the mortgage term, equal to a monthly savings of $601. That’s before fees, of course.

You can use a mortgage refinance calculator to work out various refinancing scenarios. However, be aware that many calculators omit the fees you’ll have to cough up when you refinance. The one used for our example estimated $7,348 in closing costs, reducing the overall savings to $5,570.

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Reduce Your Loan Term

Some homeowners would rather use a lower interest rate to shorten their loan term rather than cut monthly payments. For instance, you might want to change from a 30-year fixed-rate mortgage to a 15-year one. If we take the same example, we will increase our monthly payments by $58, but we will save $68,498 over the 15-year period. After fees, the net savings would be $61,150.

Obviously, you save much more money by shortening the term (at the cost of a slightly higher monthly payment) rather than simply reducing your monthly payments.

Converting Between Fixed and Adjustable Rate

ARMs usually begin with low-ball rates, but the rate inevitably climbs over time, often above the original fixed rate. When this happens, consider converting to a fixed-rate mortgage to save money each month.

However, if interest rates are falling and you don’t plan to stay in your home for more than a few years, it might make sense to convert your fixed-rate mortgage to an ARM. This will immediately reduce your monthly payments. Since you plan to stay for only a few years, you don’t have to worry about the interest rate on the ARM over the next 30 years.

The biggest mistake would be to move from a fixed-rate to an ARM just before interest rates begin to rise.

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Cash-Out Refinancing

You may be able to tap some equity in your home through a cash-out refinancing. You might be tempted to do this if you have sudden expenses or if you want to use the money elsewhere – perhaps to consolidate debt or pay for Junior’s college tuition.

Your new mortgage will have a higher principal amount than the current balance, the difference being the amount cashed out (minus fees). This type of refinancing commonly increases the number of years you’ll be repaying a mortgage, and you’ll, of course, incur the usual closing costs. Many financial experts counsel caution, as you may be tempted to repeat the process and fall into never-ending debt.

You will be paying interest on the cash you siphon, which at least is tax-deductible. But you should consider whether it makes sense to spend a dollar to get a 25-to-30-cent deduction. Bear in mind the maximum loan size on which you can deduct interest fell from $1 million to $750K for houses purchased after Dec. 15, 2017.

Summing Up

The pros for refinancing include smaller mortgage payments, reducing the loan term, or building equity faster. The major negative is the fees you’ll have to shell out at closing. These fees can take years to recoup. When deciding whether to refinance, take into account your current income and how long you plan to stay in the house. Cashing out your equity doesn’t save money, build equity, reduce debt, or decrease your monthly payments, so do so only after careful consideration. If you play your cards right, home refinancing can save you money, and plenty of it.

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Eric Bank

Eric Bank is a business and personal finance writer who has been featured in Credible, Wisebread, CardRates, Zacks and many other outlets. He holds an M.B.A. from New York University and an M.S. in Finance from DePaul University.