Refinancing seems like a no-brainer, right?
Imagine you bought a home in 2014 and got locked into a 3.98% interest rate on your mortgage. Then, in 2020 during the pandemic, interest rates plummeted. People started refinancing loans to get interest rates close to 2%.
So how does that work, exactly? Are there pros and cons to refinancing a loan? Is it ever a bad idea?
What Does Refinancing Mean?
Refinancing a loan means changing the terms of an existing loan, such as the interest rate or payment schedule. When interest rates drop, for example, many people seek to refinance their loans with a lower interest rate.
Of course, it’s not that simple. Refinancing depends on the type of loan and many other factors, such as the borrower’s credit score. The most commonly refinanced loans are mortgages, student loans, and car loans.
Types of refinancing include:
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Rate-and-term. This changes the terms of the loan agreement due to a factor such as a change in interest rates.
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Cash-out. This means the new loan the borrower takes out is for more than the original loan, and they get that difference in cash.
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Cash-in. In this case, borrowers make a lump sum payment toward their loan and then refinance for more favorable terms, such as a shorter pay-off period or lower monthly payments.
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Consolidation Refinancing. Borrowers have several loans with varying interest rates, so they streamline their approach to paying off debt by taking out a new loan based on their home equity and using that money to pay off the other debts. Now they are only paying off one loan with one interest rate.
If you’re interested in expanding your base knowledge of refinancing, this article from Investopedia provides an excellent breakdown.
When to Refinance
Refinancing seems like a no-brainer, right?
Well––maybe not. Refinancing can actually cost you money if you aren’t careful. Refinancing a mortgage requires an application, an appraisal, filing fees, and potential attorney fees, which add up. If your application is denied, that’s money out of your pocket.
So when is it a good idea?
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Expert opinions vary, but most people agree that refinancing is worth it if your new interest rate will be at least 1% (some say 2%) lower than your existing rate.
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In the case of a mortgage refinance, it’s important that you plan to stay in the home for several years for the reduction in monthly payments to justify the costs of refinancing.
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When the monthly savings are substantial enough to make a positive change in your life.
When to Not Refinance
When trying to decide whether or not it will be beneficial to refinance, consider several factors:
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In the case of a mortgage refinance, if you’re going to move within the next two years, refinancing might be much more of a hassle than it’s worth. Refinancing costs 3-6% of the loan’s principal, which usually takes years to recoup that expense through the savings generated by the refinancing.
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Your money spending habits. If you refinance to consolidate debt, there’s a chance you will continue with bad spending habits once your refinance gives you more available credit. If your unsecured debt (such as credit cards) is now backed up by your home as collateral, that means that if you are unable to pay your debt, it could result in foreclosure.
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When the math doesn’t add up in your favor. Sometimes a lower monthly rate doesn’t lead to savings if the term is extended. You may end up paying more in interest over the course of years.
If you’re curious if refinancing would be a good move for you, speak with a financial advisor (or two or three). There’s a lot of financial advice out there, and often it comes from people or organizations who are trying to sell you something. It’s always a good idea to get a second opinion on anything finance-related unless you have a decent amount of expertise on the subject at hand.