What to Know Before Refinancing Your Home

Part of being a financially savvy homeowner means knowing when it’s time to refinance.

When you refinance, or “refi,” you’re essentially replacing your existing mortgage with a new loan — typically so that you can take advantage of lower interest rates.

American homeowners are missing out on at least $13 billion a year by not refinancing their mortgages, according to a recent NerdWallet report. The study also found that 5.2 million homeowners with good credit and equity in their home could be saving an average of $215 each month by refinancing.

But a refi doesn’t make sense for everyone. So if you’re thinking about refinancing your home, here are three things you need to know.

5.2 million homeowners with good credit and equity in their home could be saving an average of $215 each month by refinancing.

1. REFINANCING COSTS MONEY

   Just because you can lower your monthly payment doesn’t mean you’ll save money. That’s especially true if you pay closing costs — one-time fees due when you take out a loan — when you refinance. Those costs generally run between 3 to 6 percent of the loan amount and can be paid out of pocket or rolled into your new loan amount. If you pay $3,000 in closing costs to refinance your loan and save $200 each month, it would take you 15 months before you have saved enough to pay for the closing costs.

   If you don’t want to pay costs upfront, you can opt for a no-cost refinance. That means you’ll pay nothing out-of-pocket when you refinance. However, you will end up paying a higher interest rate.

   You’ll want to crunch the numbers to compare your options and determine which type of refi makes more sense for you. A mortgage lender or financial professional can help.

2. YOU’RE RESETTING THE LIFE OF YOUR LOAN

   Often when you refinance, you extend the amount of time it will take you to pay off your home. Say you’re four years into a 30-year mortgage and you refinance with another 30-year mortgage. Now you’re going to be paying off your home for 34 years. You may have lowered your monthly payment but not actually be saving money. That’s because you’ll be making payments for a longer time period.

   On the other hand, if you’re switching to a mortgage that has a shorter term — say, from a 30-year loan to a 15-year loan — you’d save money over time and pay off your mortgage faster. The caveat is that shortening the life of your loan means your monthly mortgage payment will likely increase, so you need to make sure you can cover the higher monthly payments.

3. YOU COULD CASH OUT

   If you’ve built equity in your home, you may have the option to do a cash-out refinance. This enables you to take out a new mortgage for more than how much you owe on your current loan and then pocket the difference. Most mortgage lenders let you take up to 85 percent of your loan-to-value ratio — which is the amount of money you borrow from the lender, divided by the value of the home.

   Although mortgage lenders allow you to spend the cash however you see fit, you should have a good reason for withdrawing the money. If you’re going to use the cash to pay for your kids’ college, or finance a home improvement project that’s going to increase your home’s value, taking a cash-out refi could make sense. However, financial professionals typically recommend against using your home’s equity to pay for discretionary spending like that dream Hawaiian vacation.