When Does it Make Sense to Refinance a Mortgage?

Taking out a mortgage can be an arduous process, requiring due diligence on the part of the borrower and lender to ensure that the loan is appropriately structured and can be paid back in full with no future alterations necessary. 

However, just because we enter contracts with the best intentions to fulfill the obligations prescribed doesn’t mean that situations can’t change. Whether it’s personal financial reasons or external factors, there are instances when the rates and terms of a mortgage may need to be altered. 

Just as you can with a student loan, auto loan, or credit card debt, you can also refinance (i.e., pay off a loan and replace it with a new one) a mortgage. There are several unique reasons to do so, but mortgage refinancing is mainly classified as two types: rate-and-term refinance and cash-out refinance. 

A rate-and-term refinance is a fairly common example of refinancing. The remaining unpaid balance of a mortgage is paid off by a lender and replaced with a new loan, ideally with a more preferable rate and/or term for the borrower. 

A cash-out refinance, on the other hand, involves liquidating a portion of the home’s equity (i.e., the cash value that has been already paid toward the mortgage) for a specific purpose, whether it’s to pay for home improvements or pay off debt. While you can still obtain a new interest rate and terms with a cash-out, the loan principal will increase based on the amount of money (i.e., equity) taken out. 

Which option a borrower chooses depends on their personal needs and situation, but here are two examples of when refinancing might make sense. 

The terms “refinance” and “lower interest rate” might as well be synonymous. This is because the goal of refinancing is usually to save money for the borrower, which a lower interest rate can ultimately provide. By refinancing to a mortgage with a lower rate, a borrower may be able to lower their monthly payment over the life of the loan, or shorten the term (i.e., the time they have to pay back the loan) while keeping their monthly payment amount mostly the same. It all depends on the rates and terms available through refinancing, but lower interest means less money owed to the lender. 

A lower interest rate may also increase the rate at which a borrower builds equity in their home. Opportunities for a lower interest rate can present themselves in a few different ways. When national interest rates drop, typically during a recession or time of economic downturn, a borrower may be able to find a lower rate compared to the fixed- or adjustable-rate they are currently paying. Also, if a borrower experiences a sizable boost to their credit score, they may also be eligible for a lower rate through refinancing. 

Tap Into Home Equity

As previously discussed, a cash-out refinance functions very differently from a rate-and-term refinance. While the process still involves replacing one loan with another, it is distinct in that the borrower is taking money out of their equity, which will result in more money owed on the new mortgage. It is still possible to obtain a lower interest rate with a cash-out refinance, but not necessarily the goal in doing so. 

Typically, a cash-out would be used to pay for home improvements or repairs, which could benefit the borrower by increasing the property value and ultimately their equity. Borrowers may also need the money to pay off and consolidate existing high-interest debt, like that of a credit card, but should only do so if it makes sense from a financial perspective. While it may seem counterproductive to borrow against your mortgage, it may be necessary for some borrowers with compounding debt, in need of immediate cash flow.

Bottom Line

Due to the economic recession caused by COVID-19, mortgage refinancing surged in 2020 as interest rates fell to all-time lows. While a low-interest rate environment is ideal for refinancing, it’s still important for borrowers to weigh all the factors involved. Getting a lower interest rate on your variable or fixed-rate mortgage is great, but refinancing can still cost between 2% and 5% of a loan’s principal, while also requiring a new appraisal, title research, and application fees.

If you need help finding out if a mortgage refinance makes sense for you, Fiona allows consumers to compare personalized offers from top providers, fast and easy.