Interest rates have been climbing, so it may not feel like the moment to refinance, but there are reasons a rate-and-term refinance or cash-out refinance could be beneficial. How do you know if it's a smart move?
Essentially this depends on a variety of factors, including your current interest rate and your financial goals or priorities. Are you trying to save money in the long run or ease a financial burden by lowering your monthly payments, for example? Do you want to renovate a bathroom and add value to your home? In these types of cases, a refinance may be worth exploring. Here's how to figure out which option is right for you.
In a nutshell, a rate-and-term refinance (also known as a traditional refinance) is a new loan that replaces your current home loan, typically giving you a new principal and a different interest rate. It can be a good option when interest rates are lower because low interest rates generally translate into lower mortgage payments.
On the other hand, if you're looking to decrease monthly payments to free up funds for other expenses, you might want to consider a rate-and-term refinance even while interest rates are on the rise. You'll want to take your personal financial situation into account. If, for example, your credit score and history have vastly improved from when you initially bought your home, you may find that your monthly payments will be lower with a refinance.
A cash-out refinance is the same as a rate-and-term refinance except that you'll also receive a lump sum of cash to use for whatever you want. This amount depends primarily on how much equity you have in your home and how much you still owe on the house. Often, the more equity you have, the more you can borrow. (If you've paid off your entire home, you'd have 100% equity; on average, American homeowners now have more than $274,000 in equity.) Generally, after you subtract the amount of money you still owe on your mortgage, you'll be able to borrow up to 80% of your home's appraised value.
You'll pay back what you borrow in the form of a new mortgage payment that will replace your old one. Most homeowners put the money from a cash-out refinance toward paying off debts, making home improvements, paying for their kids' college tuition or funding something more personal, like a special family vacation.
Cash-out refinances have been on the rise in recent years, due in part to the dramatic rise of home prices and their values and because homeowners are suddenly finding they have far more equity than they had realized. "Many people who own their home, especially if they bought it more than a few years ago, have a growing pool of home equity," says J. Michael Collins, faculty director of the Center for Financial Security at the University of Wisconsin, Madison. So even though interest rates have come up in recent years, if a homeowner needs to borrow money, a cash-out refinance (versus credit cards or personal loans) may still be the most practical and affordable way to accomplish certain financial goals.
Refinancing a home is kind of like buying your home — again. Because, as we all know, this financial maneuver is a little more involved than, say, buying a pair of socks, this means several things.
First, you can expect the process to take some time — both on the financial lender's end and on your own. You don't want to rush into a refinance. With all the paperwork involved, most refinances take about 30 to 45 days, says Scott Kim, a Citi sales manager in Irving, TX. Additionally, because loan terms can vary widely, "people should shop around to compare cash-out and term-rate refinance rates," Collins suggests.
You'll want to look at both the interest rate being offered and what the annual percentage rate (APR) is. They're similar, except that the APR includes certain other expenses that wind up being factored into your new loan, such as the application fee and processing fee. Starting with your current lender or a local bank or credit union can be a good strategy. Because you have an existing relationship with your bank, the terms may be better — plus, they already have much of your financial paperwork.
Keep in mind that, while the interest rate is important, it's not the only determining factor. For instance, if you're looking to lower payments or you need cash, you might be able to achieve this regardless of the interest rate by tweaking the loan in another way, such as adjusting the length of the agreement.
Other considerations come into play too. "Refinancing involves significant closing costs, which vary across states due to applicable taxes and other laws," says Chandan Jha, associate professor of finance at Le Moyne College in Syracuse, NY. "Even though sometimes you might find an attractive refinancing rate, after accounting for all these costs, refinancing might not be worth it." That said, some lenders may offer credits to offset closing costs, so it's a good idea to do your research before you make any hard and fast conclusions.
Another factor is how long you plan to own the home. "The longer you stay, the more attractive it would be to refinance, as there will be plenty of time to recover these expenses," Jha says.
There can be significant benefits to refinancing, such as lowering payments or paying off a mortgage faster, if you shorten the length of the loan. But the main attraction is the end result: achieving your financial goal, such as paying less for your home or accessing cash to achieve some important life objectives. If, ultimately, you're unsure about whether you should refinance, you may want to have an accountant or mortgage attorney review your mortgage contract and weigh in on which financial transaction makes the most sense for you.
Whatever you decide, what's wonderful about refinancing is that you can operate on your own timeline. If you conclude that today isn't right for a rate-and-term refinance or a cash-out refinance, you can always do it tomorrow or multiple times down the road, if it makes financial sense. That's a big upside of owning property. Because most residences continue to build equity over time, it's more than just a place where you can build a life; your home is also a valuable asset.
The views expressed herein are those of the author and do not necessarily reflect the views of Citi. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results.