Understanding the Costs and Savings of Refinancing
When considering whether to refinance a home, it’s vital to weigh the benefits and risks. Many homeowners use refinancing to get a lower interest rate, reduce their monthly spending, or consolidate debt. However, depending on your financial situation and the terms a lender offers, a refinance could cost more in the long term than your original mortgage.
Below, we’ll examine the potential costs and savings of refinancing, including the risks you might face and what fees you should expect to pay.
Ways you could save if you refinance
Refinancing can give you breathing room to consolidate debts or obtain a new mortgage with more manageable terms or interest rates. Here are the specifics of how refinancing can help you save.
Lowering your interest rate
A top reason homeowners choose to refinance is that current refinance rates are lower compared to their existing home loan. Interest rates may have changed since the mortgage was signed, which gives borrowers another chance to lock in a lower rate on a refinanced loan, leading to potential savings.
You can estimate your potential savings using a refinance savings calculator to see if refinancing makes sense for you.
Remember that even if mortgage rates are lower overall, lower interest rates aren’t always guaranteed. Just like a standard mortgage, refinance rates depend on your current income and credit.
Lowering your monthly payment
Refinancing also allows you to change the length of the mortgage, allowing more time to pay down the loan. For instance, some people refinance from a 15-year mortgage into a 30-year mortgage, which provides a longer repayment period and lower monthly payments.
Saving on private mortgage insurance
Private mortgage insurance, or PMI, is something you’ll have to buy if you put down less than 20% of the home’s cost as a down payment. It’s provided by private insurance companies, and the borrower is typically required to buy it if their equity is less than 20% of the home’s value, both at the time of the original purchase and then again during the refinancing process.
The insurance protects the lender, not the borrower, if you fail to make loan payments. That being said, it also helps borrowers qualify for a loan when they don’t have a large sum on hand for a down payment.
However, refinancing can eliminate the need for PMI. If your principal balance on the loan goes below 80% of the original value, you can cancel the insurance. Refinancing can help you lower the balance down to that level faster.
What does it cost to refinance?
Even if refinancing for a lower rate or payment seems like a smart financial move, other costs are still involved. Closing costs often comprise a portion of the burden during a refinancing process, but you should also look out for other fees.
Closing costs and fees
Closing costs often range from 2% to 6% of the loan amount, which can cost thousands of dollars for a single-family house. Some lenders offer fixed or flat fee closing costs that remain consistent for all loan sizes.
The borrower pays closing costs to cover various expenses, such as the application fee, loan origination fee, appraisal costs, insurance, and other fees from the bank or lender. It’s important to consider these costs when looking at the long-term picture of potential savings to ensure refinancing is right for you.
Longer loan terms could cost you more in interest
Refinancing has its pitfalls, and changing the terms of your mortgage can end up costing you more money down the line, even with a lower monthly payment.
For instance, even though a homeowner can choose to refinance for a longer-term loan, giving them more years to pay it back, that longer period means more interest will accrue over the life of the loan.
Check with your lender and look at the long-term math involved in your payments under the new loan to make sure you’re ok with these new terms. Some borrowers are fine with the potential of paying more interest over time and choose to use the short-term savings immediately to make improvements to the home and increase its value.
If you want to refinance but still have concerns about interest payments, you may be able to buy down your mortgage and alleviate some of the long-term cost. Consider using a mortgage or mortgage points calculator to estimate your savings on interest using this method.
Refinancing may lower your credit score
If you decide to refinance, two major factors will affect your credit score.
The first is from the inquiry lenders will conduct into your credit file when you apply for a new loan. This kind of “hard inquiry,” as it’s known, can cause your credit score to drop slightly. However, the money you save through a refinance process can outweigh those effects. Payments on the new loan will go toward your score, and the score can improve over time.
The second factor affecting your credit score is a closed account. The old loan being refinanced will be closed, and closing an established credit account can count against your credit score. But the decrease might not be too bad if the account was in good standing and payments were made on time.
These impacts on a credit score can cause trouble when seeking to borrow money for other short-term needs or lead to higher interest rates on other loans. Still, if payments on the new loan are made on time, the score will rebound.
Is refinancing worth it?
Now that you understand the potential costs and savings, you’ll have to assess whether refinancing is right for your financial situation. This will depend on how you plan to capitalize on any lower monthly payments or extra funds.
For example, suppose a lender approves you for a favorable refinance rate. In that case, you might be able to refinance to consolidate other high-interest debts, or you might be able to use the lump sum from a refinance to make necessary repairs to your home. It’s up to you, and you should always research your potential loan and repayment terms properly before deciding.
