When people think of refinancing their mortgage, the most common thought is to lower their interest rate. And while this is always a good option to consider when lower interest rates are available, there might be other mortgage refinance opportunities to think about when the time comes. In the article that follows we talk about the different types of mortgage refinances, what are some considerations when evaluating each scenario, and when you have looked at the pro’s and con’s of each, trying to determine which mortgage refinance is best for you.
Rate and Term Refinance
A rate and term refinance is a mortgage that replaces a homeowner’s higher interest rate existing mortgage with a lower rate mortgage on their property. Rate and term refinances are the most common refinances that mortgage lenders normally do and the opportunity to save meaningful money on your monthly payment is real depending on when you purchased your home and what type of loan you have.
There is no “mortgage playbook” that says “when this happens” you should refinance your mortgage. I find that every borrower has a different threshold on what they feel is a good monthly savings to make them want to move forward with a refinance. I often say that when you can save 1% on your interest rate then that is a good starting point for moving forward. So, for example, if the interest rate on your existing loan is a 4.75% and the current rates are at 3.75% then you should seriously consider moving forward with the refinance.
But there are other considerations to take in to account and one of those is how long you have paid on the mortgage. If for example you have paid on your 30 year mortgage for 10 years and you only have 20 years left until the home is paid off, but something has come up financially and you want to refinance back to a 30 year loan again to save a bit of money on your monthly mortgage payment, I would advise against that unless there is a pressing financial reason to make that move. There are always many things to consider when looking to refinance a mortgage so weigh all of your options before moving forward.
Cash Out Refinance
The next type of refinance loan that is popular with homeowners especially in real estate markets that are experiencing high appreciation rates is called a cash-out refinance. This type of refinance is normally done by a borrower that has a lot of equity in the home and wants to tap in to that home equity to either pay off some high interest debt or finance home improvements. Truth be told, the homeowner can use the funds however they choose, but paying off high interest debt and covering the cost of home improvements are some of the better uses of cash out funds. Buying a car or taking a dream vacation would not be considered a wise use of funds from the equity in your home.
A cash-out refinance will typically have a slightly higher interest rate than a rate and term refinance because the lender and the homeowner for that matter is taking on more risk by reducing the equity in their home. Homeowners must typically have at least 20% equity in their homes to do a cash out refinance on a conventional loan so normally cash out refinance borrowers have been in their homes several years before they turn to tapping their home equity.
Refinance to Shorten the Loan Term
This is the type of refinance that I wish was more popular among homeowners because it is a great financial planning tool for most families. For most of us, our home is our largest financial asset, so it is smart to manage that asset much like we do the other assets in our portfolio that hold value. We should all set a goal to one day get our home paid off, and refinancing a mortgage from a 30 year loan to a 15 year loan is a great way to one day get that done.
The benefits of shortening the term of our mortgage are tremendous and should be a consideration for every homeowner. Shortening the term of a mortgage means paying thousands of dollars in less interest over the life of the loan which is a big financial benefit for all of us homeowners. And having the home paid off sooner than expected is the other.
The downside often cited to shortening the term of the loan is the monthly mortgage payment will rise slightly. Yes, this can be a challenge for some to commit to a higher monthly payment, but I tell clients when they get a raise and their income increases, don’t go out and buy that expensive new car with the high monthly payment. Keep your expenses low, don’t take on any unnecessary debt, and plan on evaluating a shorter term mortgage opportunity about three to five years after getting the 30 year mortgage.
Which Mortgage Refinance is Best for Me?
Each of these refinances have their pros and cons and they all will help homeowners reach their financial goals in different ways. Rate and term refinances are definitely the more popular refinance option and generally are a better choice for most borrowers and their financial situations.
A cash-out refinance is a great option to consolidate debt, pay large unexpected medical costs, pay college expenses for a child, or even start a business. It is also a great option to finance home renovations or improvements like adding a room or putting a pool in the backyard.
For those that plan to stay in their home and are already thinking ahead about their retirement planning, going from a 30 year to a 15 year mortgage is a wonderful option to get your home paid off early.
The mortgage refinance that is best for you is the one that gets you closest to reaching your financial goals. Younger homeowners might place a higher priority on lowering their payment to save more money each month, while older homeowners might have the kids away at college already and one eye on retirement. Depending on where you fall in your financial planning journey will shape which mortgage refinance might be best for you.
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