What Is Refinancing And Should You Consider It?
What is refinancing?
Most people have heard the term “refinancing” used in conversation, but do they really know what it means?
Refinancing is, at the most basic level, exchanging an existing loan for a new loan, ideally one with better terms and an improved interest rate. Most frequently, we hear of individuals who refinance their homes when market rates improve, however, there are many more applications for refinancing than your mortgage alone. Refinancing is a process available for most loans, including mortgages, auto loans, student loans, and even personal loans, such as your credit card.
Why shouldn’t you refinance? There are many possible benefits but there are also some potential implications that should be carefully considered before choosing the route of refinancing.
Advantages & Disadvantages of Refinancing
As explained by Investopedia, there are many potential advantages to refinancing existing loans.
We can analyze the costs and benefits of refinancing an existing mortgage.
Refinancing can enable individuals to lower their monthly payments or shorten the term length of their loan.
Refinancing can allow individuals to establish greater equity in their home, particularly if the appraisal value has changed since initially taking out the loan.
Overall, the incentive for refinancing is typically to obtain a lower interest rate and generally improve the terms of the loan.
However, despite the many advantages of refinancing, there are also several sizable disadvantages that can potentially occur when refinancing.
Not everyone will qualify for refinancing as there are certain standards that must be met to be eligible. Typically, one must have at least twenty percent equity in their home to refinance. If they have not established twenty percent equity in the home, they will have to have a strong credit rating to be eligible and may still face higher interest rates and be required to carry Private Mortgage Insurance (PMI) in order to protect the lender.
The process of refinancing can be both lengthy and costly in nature. The process typically requires a substantial time commitment to complete the required paperwork as well as carries a cost averaging between 3-6% of principal.
For these reasons, those looking to refinance should carefully consider their options and calculate how long they will need to remain in the home to benefit from their investment in refinancing.
Important Considerations
So, what should one take into consideration when evaluating refinancing?
One should assess how long they will realistically remain in the home. It takes time to recoup the savings associated with refinancing, typically due to an initial upfront cost and time commitment to the process. As an example, a couple who is just a few years in to a thirty-year mortgage will be far more likely to recoup their savings on refinancing than a couple who is ten years in to a fifteen-year mortgage with plans to relocate within two years. Sometimes things, like divorce, can happen unexpectedly. Many people are forced to decide whether or not they should keep their home after divorce. Be sure to take challenges like this into account when thinking about how long you’ll be in that space.
In addition to one’s time horizon, individuals should also consider how much their rate will decrease by refinancing. As a rule of thumb, if the rate will decrease by 1% or more, then it may be worthwhile to evaluate refinancing. However, a lower rate does not necessarily equal cost savings. For instance, if one were to refinance a thirty-year mortgage five years in, if the mortgage is replaced with a second thirty-year mortgage, it is likely they may pay more in interest over the total loan term.
Because refinancing involves changes in the terms of the loan, be sure to consider whether your new loan has a variable interest rate or if it is fixed. A rate decrease of 1% from a fixed to a variable loan may not be worth it because the new variable rate has the potential to change over time. This is just an example, which is why you should always consult a financial professional before jumping into a refinance.
Individuals considering refinancing should be aware of the costs associated with the process. Closing costs might include title insurance, attorney’s fees, transfer fees, appraisal costs, taxes, and more. Knowing ahead of time what the associated costs might be will help those considering refinancing to make a more informed decision in line with their financial goals.
Private Mortgage Insurance (PMI) — What is it?
As previously mentioned, Private Mortgage Insurance may be a costly requirement in some instances for refinancing. Changes to the value of homes can result in unanticipated costs. In periods during which the value of homes is declining, a lower appraisal value can mean that one no longer has sufficient equity in the home to satisfy a down payment on the new mortgage.
As a result, a larger cash deposit or Private Mortgage Insurance may be required, both of which will ultimately increase the monthly payment. If Private Mortgage Insurance is required, it will likely mitigate any material costs savings and therefore, it may not be worth the effort to refinance.
On the other hand, for those who currently carry PMI, refinancing may allow you to remove PMI coverage and save on monthly expenses. If your home has more than 20% equity, you should not be required to carry Private Mortgage Insurance unless you are a particularly high-risk borrower, or you currently have a Federal Housing Administration (FHA) mortgage loan.
Potential Implications
To conclude, there are several other potential implications of refinancing.
Refinancing can influence your credit score, for better or for worse. Typically refinancing will lower your score because long-standing debt tends to be better for your score than new lines of credit. However, depending on one’s unique financial situation, fluctuations in their FICO credit score may be comparably insignificant in line with the potential costs savings over the loan term. To counteract the impact of refinancing on their credit, individuals should try to limit how often they inquire when rate shopping and should not refinance too frequently.
Refinancing can also have implications for your household net worth. As explained by Investopedia, when a mortgage balance increases as a result of refinancing, ones liabilities will increase. Therefore, if all other forces remain constant, their household net worth will decrease by an amount equal to the total refinancing costs. All of this can potentially impact your ability to properly invest for retirement.
In Conclusion
All-in-all, refinancing can be a very powerful tool for homeowners when used thoughtfully to their advantage.
However, refinancing for the sake of refinancing can often lead to unexpected expenses, substantial time commitments, and even increasing costs over the life of the loan.
Written by Kaitlyn Keeler
Kaitlyn is an enthusiastic client service intern that assists our advisors with your accounts. She is an attentive business student with a concentration in finance.
