Refinancing Your Home Loan: What Is It and Why Should I Do It?

Understanding When to Refinance

You see that dog? You deserve to sleep as peacefully as that. One way of doing that? Understanding how refinancing works for your mortgage and if it makes sense for you to do it. 

Refinance this, refinance that, what does refinance even mean? Before diving into other explanations of what refinancing is and why people refinance, in simple terms, refinancing your home loan means you are getting a new loan to pay off your old one. Sounds simple enough, right? Refinancing your home loan can be a smart financial decision for various reasons. However, for those who bought a home during the historically low interest rates around the time of Covid-19, you most likely will never need to refinance again unless you plan to purchase a new home or have some other capital allocation purpose. Before you start the process, ask yourself why you want to refinance, as this will guide the entire refinancing process from start to finish. Here are some of the most common reasons for refinancing: tapping into equity, reducing your monthly payment, paying off the loan faster, getting rid of FHA mortgage insurance, or switching from an adjustable-rate mortgage to a fixed-rate loan.

Tap Into Equity — When you have built up enough equity in your home (by making regular payments over time), you may be able to borrow more than you owe on the current loan by refinancing. This allows you access to funds that can be used for anything from home renovations or repairs to investing in other projects or businesses.

Reduce Monthly Payment — When your goal is to pay less every month on your mortgage payments, refinancing into a lower interest rate is definitely one way to achieve this goal. If you’ve been in your current loan for several years and interest rates have dropped since then, now may be the perfect time to refinance and save money on your monthly payments.

Refinancing into a lower interest rate mortgage can be an excellent way to save money on your monthly payments. By shopping around for the best possible rates and terms, you could potentially save hundreds of dollars each month over the life of the loan. For example, a homeowner with a 30-year fixed-rate mortgage of $300,000 at 5% interest rate could potentially save more than $176 a month by refinancing into a 4.5% loan. You can easily see the financial benefits then if you are able to get a lower interest rate by 1% or more. The benefits of the annual savings would far outweigh the cons of the costs to refinance.

Pay Off the Loan Faster — Refinancing from a 30-year mortgage into a 15-year loan can cut the length of time it takes to pay off your loan in half! The shorter timeline means that you could save thousands of dollars in interest over time and reach financial freedom sooner than if you had stayed with a longer term loan. You would typically not refinance into a 15-year from a 30-year mortgage if you did not have some equity built in addition to refinancing into a lower interest mortgage. Some other reasons when it might make sense to switch to a 15-year fixed even if you have not built much equity or if interest rates are not that much different would be if your financial situation improved (new job, salary increase, are no longer on single income, was given an inheritance, or many other financial changes).

Get Rid of FHA Mortgage Insurance — If you currently have an FHA loan with mortgage insurance attached (which is required by law for loans where the borrower still owes 80% or more of the loan), you can refinance into a conventional mortgage where PMI isn’t necessary if there is enough equity built up in the home. This could potentially save you hundreds each month on payments. Just know that it is more difficult to qualify for a conventional loan than it is for an FHA loan due to an FHA loan being insured by the Federal Housing Administration.

Switch From an Adjustable-Rate Mortgage To A Fixed-Rate Loan — Interest rates on adjustable-rate mortgages can go up substantially over time depending on market conditions; however, when locked into a fixed-rate loan with no prepayment penalties, borrowers know exactly how much their monthly payment will stay unchanged even when interest rates increase — providing peace of mind and allowing them better budgeting control long term. Often times, people choose to do an adjustable-rate mortgage to capture lower rates than a fixed-rate loan may initially provide, but that is with the understanding that the market will provide more attractive rates than the current rates, otherwise the borrower may be poorly positioned when the fixed period of the ARM (adjustable rate mortgage) ends and be stuck paying higher monthly payments due to increased interest rates.