Refinancing is a financial option that lets you get a new mortgage to pay off your existing one. The process is generally the same as getting a mortgage for a new house, but what exactly is refinancing used for? And when does it make sense to refinance a home?
When Does It Make Sense to Refinance a Home?
Of all the financial options that we have available to us, refinancing tends to make the least amount of sense and can be seen as a strange thing to do. However, there are actually a couple of good reasons to refinance, and it may even help you save money depending on what your financial goals are. In this post, we’ll be taking a look at some of those situations so you can gain a better understanding, and likely save some moolah in the process!! 🙂
One of the most common reasons to refinance is to take advantage of lower interest rates.
When market interest rates fall, it’s possible to refinance and get a lower rate on your monthly payments. There are a lot of things to consider when looking at refinance rates, and it’s going to heavily depend on market conditions and what you have access to.
You could find a lower interest rate because there isn’t much left of your mortgage to pay off.
For example, if you only have half of your mortgage left to repay, then you could end up getting a much better deal over the next few years (because the risk to the bank is now much lower since your house is still listed as collateral should you default).
You’ll need to do a bit of research and speak with a financial advisor to help you calculate this, but it could save you quite a bit of money over the long term.
You could find a lower interest rate because of an improved credit score.
With a higher score, you’ll gain access to better interest rates on your mortgage.
If you’ve drastically improved your credit score from when you first took out your mortgage, then you could unlock a much better interest rate. But in most cases, if you’re close to paying off your entire mortgage, then refinancing can help you get a lower interest rate as well.
Mortgages tend to be huge term lengths that can go up to 30, 40, or even 50 years in some cases!
Monthly payments on a long-term mortgage tend to be lower, but interest rates may be higher and it will take a very long time to pay it all off.
However, if you can actually afford higher payments each month due to your circumstances changing, then it may be beneficial to refinance and aim for a much shorter loan term (because in the shorter term, you’ll end up paying fewer dollars toward interest).
For example, if you can shorten a 20-year loan to just 10, then you’ll be paying twice the amount of money each month but you can drastically reduce the amount of interest you’ll be paying.
The interest savings can be extremely beneficial, but you may already have a fairly low-interest rate if your credit score was high at the time that you took out your loan.
There are a number of factors to consider here and you should speak with a financial advisor or take a good look at your financial situation before deciding to refinance for a shorter loan term. Should something happen to your circumstances, you might have difficulties paying off the higher monthly payments.
You can access more of your home’s equity with refinancing
A significant number of refinancing deals actually led to owners taking cash out. These kinds of refinancing rates can be a little higher, but it’s actually a fairly cheap way to borrow money if you need to fund a project of sorts. I don’t condone this as I’d much rather you pay cash for any type of home project, BUT this is getting so common, that I can’t ignore the point. And, be sure to check with a financial advisor to see if it’s actually worth it to refinance a home for the sake of borrowing the money.
Borrowing money to fund a project
If you’re set on borrowing money to refund a project, there are potentially cheaper ways to do this. One of these methods is a home equity loan. However, if there are no other options or you believe that you can unlock a lot of equity from your home with refinancing, then it remains a solid option assuming you can afford the payments.
Based on the Math…When Does It Make Sense to Refinance Your Home?
For most of us, refinancing our home has less to do with shortening the term of our mortgage or funding a home project. It’s all about the dollars and cents.
In other words…
“Will refinancing my home save me thousands of dollars in the long run? If yes, then cool, let’s do it so I can have more moolah for something else!!”
Doing the break-even analysis of refinancing your mortgage
When you refinance a house, you’re going to experience a major cost because it takes the bank a considerable amount of work to do the deal (Remember? Refinancing your house is basically like borrowing to buy it all over again.)
All in all, it typically costs 2-3% of your mortgage balance to refinance your mortgage.
If you’ve got a $200,000 mortgage, then this amounts to $4,000-$6,000 of up-front costs.
Well…that’s a pretty serious chunk of change!
How can you know if refinancing your house is really worth it?
First, you’ve got to figure out how long it will take you to break even. Sounds complex, but don’t worry, this is actually pretty simple.
- Let’s say your mortgage payments were $1,500 a month.
- Without changing the term of your mortgage, you could reduce your payment by $400 and bring it down to $1,100 (simply due to interest savings)
- After 12 months of saving $400 a month, you’d save yourself $4,800 a year!
- So, if your up-front closing costs amounted to $4,800, that means you’d make your money back in one year!
And, to carry this just one step further, let’s say you only saved yourself $200 a month on your payment (instead of the $400 in the example above), then you’d only save $2,400, which means it would take you two years to break even on your initial refinance investment.
So…what’s considered good? If you can recoup your money in say, five years, is refinancing still a good move?
Based on my experience and based one what I’ve heard and read about, I’d stick with a three year cut-off. Meaning, if it takes you longer than three years to get your money back from a refinance, then it’s probably not worth it.
Life changes rapidly.
- You could have a medical emergency,
- you might have to move for work,
- maybe you get married during that time….
There are a ton of reasons that would cause you to move from that home that you recently refinanced. And, if you move, that means you’re no longer benefiting from that reduced payment. So, anything more than a three-year payback…it just doesn’t make a ton of sense in my book.
On the flip-side, if your payback is only a year and you plan to stay in that house for many many years, then heck yes I’m going to refinance!
Because not only are you going to save money in that first year, you’re going to continue to save money every year thereafter! The longer you stay in that house, the higher those refi savings are going to mount!
When Does It Make Sense to Refinance a Home? Mainly…to save money…soon
There are plenty of good reasons to refinance a home, but you’ll want to make sure that you’re looking carefully at your options to see if refinancing makes the most sense for you. If you’re simply looking to borrow for a project, think carefully as that’s a pretty big move for a cosmetic update.
But, as we just discussed, if you’re looking to save money on your payments for the long term and you’ve got a break-even of less than three years on that initial refinance cost, then it probably does make sense to refinance and get that lower interest rate!
So how about you? Are you going to take the plunge and refinance your mortgage? Why or why not?
AUTHOR Derek Sall
Derek has a Bachelor's degree in Finance and a Master's in Business. As a finance manager in the corporate world, he regularly identified and solved problems at the C-suite level. Today, Derek isn't interested in helping big companies. Instead, he's helping individuals win financially--one email, one article, one person at a time.