Refinancing can save you money or cost money

Refinancing a mortgage means paying off an existing loan and replacing it with a new one. There are many reasons why homeowners refinance:

• To obtain a lower interest rate
• To shorten the term of their mortgage
• To convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, or vice versa
• To tap into home equity to raise funds to deal with a financial emergency, finance a large purchase, or consolidate debt

Refinancing to Secure a Lower Interest Rate

Refinancing can save you money or cost money. One of the best reasons to refinance is to lower the interest rate on your existing loan. Historically, the rule of thumb is that refinancing is a good idea if you can reduce your interest rate by at least 2%. However, many lenders say 1% savings is enough of an incentive to refinance.

Reducing your interest rate not only helps you save money, but it also increases the rate at which you build equity in your home, and it can decrease the size of your monthly payment. For example, a 30-year fixed-rate mortgage with an interest rate of 5.5% on a $100,000 home has a principal and interest payment of $568. That same loan at 4.1% reduces your payment to $477.

Refinancing to Shorten the Loan’s Term

When interest rates fall, homeowners sometimes have the opportunity to refinance an existing loan for another loan that, without much change in the monthly payment, has a significantly shorter term.

Refinancing to Convert to an ARM or Fixed-Rate Mortgage

While ARMs often start out offering lower rates than fixed-rate mortgages, periodic adjustments can result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to fixed-rate mortgage results in a lower interest rate and eliminates concern over future interest rate hikes.

Conversely, converting from a fixed-rate loan to an ARM—which often has a lower monthly payment than a fixed-term mortgage—can be a sound financial strategy if interest rates are falling, especially for homeowners who do not play to stay in their homes for more than a few years.

These homeowners can reduce their loan’s interest rate and monthly payment, but they will not have to worry about how higher rates go 30 years in the future.

If rates continue to fall, the periodic rate adjustments on an ARM result in decreasing rates and smaller monthly mortgage payments eliminating the need to refinance every time rates drop. When mortgage interest rates rise, on the other hand, this would be an unwise strategy.

Refinancing to Tap Equity or Consolidate Debt

Refinancing can save you money or cost money.

While the previously mentioned reasons to refinance are all financially sound, mortgage refinancing can be a slippery slope to never-ending debt.

Homeowners often access the equity in their homes to cover major expenses, such as the costs of home remodeling or a child’s college education. These homeowners may justify the refinancing by the fact that remodeling adds value to the home or that the interest rate on the mortgage loan is less than the rate on money borrowed from another source.

Another justification is that the interest on mortgages is tax-deductible.1 While these arguments may be true, increasing the number of years that you owe on your mortgage is rarely a smart financial decision nor is spending a dollar on interest to get a 30-cent tax deduction. Also note that since the Tax Cut and Jobs Act went into effect, the size of the loan on which you can deduct interest has dropped from $1 million to $750,000 if you bought your house after Dec. 15, 2017.2

Many homeowners refinance to consolidate their debt. At face value, replacing high-interest debt with a low-interest mortgage is a good idea. Unfortunately, refinancing does not bring automatic financial prudence. Take this step only if you are convinced you can resist the temptation to spend once the refinancing relieves you from debt.