Pros & Cons of Refinancing Your Home Mortgage Loan

refinancingMortgage refinancing isn’t a new concept, but whenever there’s a significant drop in mortgage rates, it’s not unusual for mortgage lenders to receive an influx of applications. Refinancing is the process of attaining a new mortgage to pay off an existing mortgage. The new mortgage comes with entirely new terms, which are typically better for the homeowner.

There are good reasons to refinance a mortgage loan. Perhaps you’re cash-strapped and desperately need to reduce your monthly payment to avoid foreclosure. Or maybe you agreed to a bad mortgage loan and want to acquire better terms.

However, despite the many benefits, refinancing has its flaws. Familiarize yourself with the pros and cons of refinancing, and then decide whether now is the time to take out a new mortgage.

Benefits of Refinancing Your Mortgage Loan

Didn’t get the mortgage process right the first time around? A refinancing can undo a bad mortgage deal and help you acquire the most favorable mortgage terms.

1. Lower Interest Rate
The opportunity to obtain a lower interest rate is a top reason to refinance a mortgage loan. For cash-strapped homeowners, it’s a solution that can keep them in their home and preserve their credit, as a refinance can not only lower the interest rate on a mortgage loan, but also the mortgage payment.

For instance, the monthly difference on a $250,000 mortgage loan with a 6% interest rate and a 4% interest rate is nearly $300 per month. For anyone struggling financially, a $300 mortgage decrease can be the break they need to stay in their home.

2. Convert an Adjustable Rate Mortgage to a Fixed Rate
Adjustable rate mortgages (ARM) typically feature lower rates for the first few years of the mortgage term than fixed-rate mortgages, which is why they’re a popular choice among some home buyers. For example, you could have an ARM with a fixed period of one year or ten years, during which time the interest rate won’t change. However, the interest rate shifts when the initial fixed period expires. It adjusts according to a benchmark index, such as the LIBOR, which can trigger an interest rate hike and a higher mortgage payment.

ARMs are ideal for people who foresee living in their houses for only a short length of time. But if you plan on sticking around for several years, a fixed rate is your best bet. Predictable payments coupled with historically low rates make refinancing into a fixed rate mortgage an excellent deal for many people.

3. Cash Out Your Equity
Equity is the difference between your house’s worth and what you owe the mortgage lender, and selling your house is one way to tap your equity. But if you’re not ready to move, another option is a cash-out refinance. You basically borrow against your equity and refinance for more than your house’s current principal balance. Then, use the additional cash to pay off your debt, make home improvements, start a business, or put toward your kids’ college tuition.

Of course, this can also be a downside, as it gets you deeper in debt and may increase your mortgage payment. Plus, trading credit card and other unsecured debt for debt secured by your home could lead to you losing your home in the event that you can’t make mortgage payments. This wouldn’t necessarily be the case if you default on your credit card debt.

mortgage contract

Drawbacks of Refinancing Your Mortgage Loan

A refinance can make good financial sense, but the process isn’t always so clear-cut.

1. Applying for a New Mortgage
You might excitedly apply for a refinance with the hopes of lowering your mortgage rate and saving money on your home loan each month. But if there’s been any change to your income or credit since applying for your original mortgage, this can stop a refinancing in its tracks.

Your income and credit are more important than ever. Mortgage lenders are cautious and will scrutinize your credit report and financial information, and may not approve you – or approve you at a higher rate – if your credit score has dropped or if you’ve recently suffered a job loss or a reduction in salary. Be aware that having an existing mortgage does not guarantee a refinance approval. Your lender may request copies of tax returns and recent paycheck stubs to verify your income.

2. Refinancing Costs
The cost of a new loan is one of the biggest hurdles to refinancing. Some homeowners are caught off-guard when they’re required to pay closing costs, which range between 3% and 6% of the loan balance. Fees include the home appraisal, the application fee, the title search, the credit report fee, discount points, and the loan origination fee.

Mortgage-related fees are paid out-of-pocket at closing, but some lenders include these fees in your loan balance. Plus, if you’re refinancing into an FHA loan, for example, you’ll need to pay an upfront fee for mortgage insurance.

3. Low-Ball Appraisal
Home appraisals estimate a property’s worth, and they are inevitable when refinancing. The appraiser uses recent comparable sales in the community to assess a home’s value, and the results of an appraisal can make or break the deal. There are government refinance programs to help upside-down borrowers, wherein they can refinance with no equity. But if applying for a traditional refinancing, many lenders require some equity.

In this case, a low-ball appraisal can destroy any chances of acquiring a new mortgage and better terms. The appraiser may conclude that a property is worth far less than what’s owed, thus prompting a lender to deny a refinance request.

In some cases, appraisers must use foreclosed properties in the area to make comparisons when determining a home’s value. In this situation, it may make sense for homeowners to either postpone refinancing until they acquire additional equity or until housing values recover.

Final Word

While refinancing a mortgage loan isn’t the simplest process and mortgage lender requirements are specific, this is one of the best ways to lock in a low fixed rate and potentially reduce your mortgage payment. If you’re current on your existing mortgage and other debts, have a credit score of at least 680 (620 for an FHA mortgage refinance), have cash on hand for mortgage expenses, and can verify your income, now may be the right time to take out a new mortgage loan.

What do you think are the biggest advantages or disadvantages to refinancing a mortgage?

  • Kevin Haney

    The biggest disadvantage to refinancing is that people over estimate the amount of time they will stay in one home, or pay into any existing mortgage. They either more or refinance much sooner than planned and fail to recoup the closing costs, or simply extend the loan term.

    So much of mortgage interest is front loaded. Even though the periodic rate may be low, the percentage of payment going to interest is very high. Banks love when people turn over loans, as this resets the amortization schedules.