If you purchased your home when the federal funds rate was at least 150 basis points — 1.5% — higher than today, an opportunity to profit from low interest rates is staring you in the face. In fact, there’s a good chance it’s surrounding you as you read these words.
Like millions of other homeowners paying more than necessary each month, you can take advantage of current low interest rates by refinancing your mortgage loan.
Knowing whether you should refinance your mortgage is trickier. Before you can decide, you need to know more about its upsides and downsides, including the potentially negative consequences for your personal finances and housing security.
Pro tip: If you decide that refinancing is the best option for you, Credible* will allow you to compare prequalified rates from multiple lenders in just minutes.
Advantages of Refinancing Your Mortgage Loan
Refinancing your mortgage loan could give you a financial boost by reducing your overall borrowing costs or creating low-cost financial leverage for home improvement projects and other financial goals. Many refinancing applicants realize more than one of these benefits.
1. It Could Reduce Your Lifetime Interest Costs
Reducing lifetime interest costs — and your total borrowing costs along with them — is among the most compelling reasons to refinance a mortgage. Many homeowners refinance with this objective in mind. They want to save money, and who can blame them?
Depending on the structure, type, term, and rate of your original loan, refinancing your mortgage could reduce your total interest expense in one or more ways:
Lowering the Interest Rate. Getting a lower interest rate is much more likely to occur if rates have fallen since your original loan’s issue and critical elements of your borrower profile — such as your credit score, income, and debt-to-income ratio — remain constant or improve.
Shortening the Term. A shorter term means less time for interest to accrue. The downside is the potential for a higher monthly payment.
Converting From Adjustable Rate to Fixed Rate. Refinancing your adjustable-rate mortgage loan into a fixed-rate mortgage loan eliminates the risk your interest rate will spike if prevailing rates rise.
Converting From Jumbo to Conventional. Jumbo loans generally carry higher interest rates than conforming (conventional) loans. Once your remaining balance drops below the conforming loan limit (about $485,000 in most markets), refinancing could reduce your lifetime borrowing costs.
2. It Could Lower Your Monthly Payments
Simply refinancing a higher-rate loan into a lower-rate loan with an equivalent term is likely to lower your monthly payments.
If a lower rate isn’t in the cards, a less desirable alternative is to refinance into a longer-term loan and spread your payments over a longer timeframe. The downside of this move is a higher lifetime borrowing cost.
3. It Could Increase Your Loan’s Predictability
Predictability isn’t a concern if your original loan has a fixed rate. You experience year-to-year variation on the escrow side, as your property taxes and insurance fluctuate. But your principal and interest payment remain fixed for the life of the loan.
But if your original loan has an adjustable rate, predictability is a problem, and refinancing to a fixed-rate loan is a reasonable solution. If your new fixed-rate loan prevents a costly upward rate adjustment, all the better.
4. It Could Eliminate Mortgage Insurance
The FHA mortgage loan program has helped millions of first-time homebuyers afford places of their own. Maybe you’re among them.
If so, you know that your FHA loan carries a hefty cost: high annual mortgage insurance premiums that remain in force for at least 11 years from the issue date (on loans issued after June 2013) — and permanently, in some cases.
Refinancing your FHA loan into a conventional loan could eliminate its annual mortgage insurance premium years ahead of schedule. You need only wait to accumulate 20% equity in your home, which should happen much sooner than 11 years (and certainly sooner than 15 or 30 years) after your original loan’s issue.
And as long as you have at least 20% equity when you refinance, you’ll avoid private mortgage insurance (PMI) as well.
5. It’s a Low-Cost Way to Tap the Equity in Your Home
If you plan to refinance anyway to take advantage of low interest rates, a cash-out refinance loan is a fine alternative to a home equity loan or line of credit.
Like those home equity products, a cash-out refinance loan is secured by the home’s value itself, reducing risk for the lender and facilitating rates far lower than credit cards and unsecured personal loans.
You can use this low-cost capital for basically anything, including:
Consolidating higher-interest debt
Financing major home improvements or repairs
Paying your kids’ college bills
Paying off your student loans
Settling medical bills and other major expenses
Disadvantages of Refinancing Your Mortgage Loan
Refinancing your mortgage is not a risk- or hassle-free endeavor.
Potential drawbacks include an arduous application process, no guarantee of approval or cost savings, the potential for a higher monthly payment, and the risk — heightened in down markets — that the required lender appraisal could actually backfire.
1. The Application Process Is a Pain
Applying to refinance your mortgage isn’t quite as involved or time-consuming as applying for a purchase loan. But it’s not a walk in the park or something to do on a whim.
As you did before your purchase loan, you must provide reams of documentation verifying your employment, income, and identity. And the deal won’t be done until you close, leaving you on pins and needles for weeks. Don’t go through with it unless you’re serious about refinancing.
2. Approval Is Not Guaranteed
The fact that you own your home doesn’t entitle you to refinance its mortgage.
If your borrower profile has deteriorated due to a drop in your credit score or income, a recent job change, or a higher debt-to-income ratio, your application could be denied outright or accepted on less favorable terms than expected.
3. You’re Not Guaranteed to Break Even
Most refinancing applicants expect their new mortgage loans to cost less than their original loans.
But there are plenty of scenarios in which that doesn’t pan out — and not just because the borrower intentionally refinances into a longer term (going from a 15-year to a 30-year mortgage, for example) or can’t find a lower rate.
If fate intervenes and you must sell your house before you break even on your refinance loan, you’ll never recoup your loan’s upfront costs.
And because all refinance loans have closing costs that push breakeven time into the future, you’ll have to wait some time — usually several years — before you sell.
4. Your Monthly Payment Could Increase
If your objective is to cash out some of your home’s equity or shorten your loan term, your monthly payment will probably increase. Nevertheless, the jump might come as a shock and can put a severe strain on your monthly budget over time.
Before taking out a loan that costs more than your current mortgage payment, be as sure as you can that it will remain affordable.
5. It Could Backfire in a Down Market
If home values in your area have declined since you purchased or last ordered a professional appraisal on your home, you run the risk of a lowball appraisal that squelches your chance of qualifying for a refinance loan anytime soon.
This outcome is likelier in areas with high (or increasing) rates of foreclosures and short sales. If you suspect an appraisal would do more harm than good and don’t urgently need to refinance, wait until the market improves.
Refinancing a mortgage is not something to be done on a whim. Even when interest rates are low and your borrower profile is strong, the undertaking is no sure thing.
A forced relocation could compel you to sell your house years before you planned, wiping out most of your loan’s expected savings and causing you to lose money on the deal.
An unexpected job loss could threaten your family’s financial stability and put you at risk of losing your home.
A market downturn could leave you with less equity than you expected, putting your home improvement plans on hold.
Then again, you could see your refinance application approved without a hitch, reap thousands upon thousands of dollars in savings after closing costs through a lower monthly mortgage payment, and avoid the downsides of the unconventional loan that had outlived its purpose the day you first closed on your home.
There’s simply no way to predict what will happen. But as is always the case when the stakes are high, fortune favors those who know what could go wrong — and what could go right.
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