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As mortgage rates decrease, you may hear a lot about refinancing in the news. Basically, refinancing means trading in your original home loan with a new mortgage, either through your current lender or a different one. And while this process offers many benefits — such as allowing you to lock in a new interest rate or lower your monthly payments — it also comes with some drawbacks that could potentially be a deal breaker.
Before signing on the dotted line, understand the pros and cons of refinancing your home so you can make the right decision for your house and family.
In this article:
Pros of refinancing a home loan
The process of refinancing a mortgage loan may not be fun, but these benefits can make it worth the effort.
Potentially lower mortgage interest rate
One of the most common reasons homeowners refinance their mortgages is to unlock a lower mortgage interest rate, especially if rates have dropped since they first took out their home loan. A lower interest rate can save you a good chunk of change on interest payments over the life of the loan.
Let’s say you took out a $200,000 mortgage with a 30-year fixed term and 7% interest rate, resulting in a monthly payment of $1,331 toward your principal and interest. If refinancing reduces your mortgage interest rate to 5%, your monthly payments will drop to $1,074.
Of course, it won’t be quite as simple as the above equation. Your new monthly payment will also depend on your outstanding loan balance, new term length, and recurring fees like property taxes and homeowners insurance. But this example should give you an idea of how a lower mortgage rate can save you money.
Option to tap your home equity
You may be eligible for a cash-out refinance if you have at least 20% equity in your home. This type of mortgage refinance helps you tap the equity in your house to cover big-ticket purchases or expenses like medical bills or home improvement projects. A cash-out refinance replaces your original loan with a new, bigger one. You’ll then receive the difference between the two in a lump-sum payment that you can use for any purpose.
Be careful when using money from a cash-out refi to pay off unsecured debt, such as student loans or a personal loan. While there can be consequences for not paying off these debts, it’s riskier to be unable to afford mortgage payments — you risk facing foreclosure and losing your home. However, if you’re drowning in high-interest debt (maybe with credit cards), a cash-out refinance could be a smart choice since mortgage rates are usually lower than credit card rates. Weigh the pros and cons of cashing out before making your decision.
Learn more: 7 types of home refinance loans
Ability to change loan terms
If you’re unhappy with your current loan features, refinancing allows you to adjust and tailor your mortgage to meet your needs better. For example, you can shorten your loan term to pay off your mortgage sooner or switch from an adjustable-rate mortgage to a fixed-rate one for more predictable payments. You can also lengthen the loan term if your priority is to lower your monthly payments.
Dig deeper: Compare adjustable-rate and fixed-rate mortgages
Remove private mortgage insurance
If you took out a conventional home loan and put down less than 20%, you’re most likely paying private mortgage insurance (PMI), which protects the lender should you default on your mortgage. According to Freddie Mac, monthly premiums for PMI generally range from $30 to $70 for every $100,000 you borrow. This can add hundreds of dollars to your monthly payments, depending on the size of your home loan.
The good news is that PMI isn’t permanent. Your lender has to cancel your PMI once you reach 22% in home equity, but you can request to remove it when you have 20% equity. You can also get rid of PMI if you refinance with 20% equity in the house. So, if your home value has gone up or you’ve paid down a significant chunk of your loan balance, refinancing to a new loan can help you eliminate this extra cost.
Disadvantages of refinancing a home loan
Though refinancing your mortgage can help you change the term of your current loan, lower your monthly payments, and get rid of PMI, you still need to be aware of some downsides.
Closing costs
Refinancing isn’t free. You’ll have to pay closing costs each time you refinance, and these costs are typically anywhere from 2% to 6% of your remaining loan balance.
Here are just some of the potential costs involved in refinancing:
These expenses can quickly add up and cancel out the benefits of refinancing. Do the math beforehand to see how much you’ll pay on closing costs and how long it will take you to recoup those expenses with lower mortgage payments. This is what’s known as your break-even point. For example, if your break-even point is three years and you don’t plan to stay in the house that long, refinancing probably won’t make financial sense.
Potentially higher long-term expenses
A common reason homeowners refinance is to reduce their monthly mortgage payments, often by extending their loan term to 30 years. If this is what you’re looking to do, just know that you could end up paying more interest over the life of the loan since you’re stretching your mortgage out over a longer period. Use our mortgage calculator to crunch the numbers and understand the impact of lengthening your loan term.
Potentially higher monthly payments
On the other hand, if you’re refinancing to shorten your repayment timeline, expect your monthly mortgage payments to increase. Let’s say you are refinancing out of a 30-year mortgage term and into a 15-year one. Your monthly payments would increase because you’re paying off the loan in a much shorter timeframe. Shortening your loan term through refinancing may not be your best option unless you can afford higher monthly mortgage payments.
Read more: 30-year vs. 15-year mortgages
More debt
While a cash-out refinance lets you borrow against the equity in your home, it also results in taking out a larger loan than you would with a standard rate-and-term refinance. And because you’re borrowing more, your overall debt level will go up. This can lead to a higher debt-to-income ratio (DTI), potentially making it more challenging to secure loans in the future since lenders might see you as a higher risk.
When does it make sense to refinance your mortgage?
Refinancing isn’t for everyone, and it doesn’t always make financial sense. Just because your neighbor is refinancing doesn’t mean you should.
If your goal is to save money by refinancing, it can be a good idea if you’re planning to stay in the home beyond the break-even point.
The break-even point applies to cash-out refinances too. If you’re tapping your home equity to finance a home improvement project, you’ll want to calculate your break-even point by factoring in the closing costs, the cost of the home repairs, and the amount you expect to get back in added value when you eventually sell the house.
Whatever your reason for mortgage refinancing, weigh the pros and cons before moving forward. Also, consider talking to a loan officer, lender, or mortgage broker if you need help deciding whether you’re in a good spot to refinance.
Dig deeper: 6 times when it makes sense to refinance your mortgage
Refinancing a home pros and cons: FAQs
Does refinancing hurt your credit?
Yes, refinancing can hurt your credit score since the lender will need to do a hard credit inquiry to check your score when you apply. But it’s usually just a small and temporary dip.
How many times can you refinance your home?
You can refinance your home as many times as you like since there aren’t any hard and fast rules regarding how often you can refinance your mortgage. However, some lenders enforce a waiting period before borrowers can refinance their loans, so you’ll want to check if any apply to you.
What happens to your existing loan when you refinance?
When you refinance, your original mortgage is replaced with a new loan, typically with a different loan term and interest rate. Your lender will then pay off your old mortgage with the new one, leaving you with just one mortgage loan.
This article was edited by Laura Grace Tarpley.