Recently on our financial forum a user asked, “Interest rates are at an all-time low. My wife and I currently have a 30-year mortgage. I am wondering if it makes sense to refinance our loan. I guess we could either modify it to a 15-year mortgage or at least get a lower interest rate on our 30-year mortgage. What are the main reasons that people decide to refinance?”
What is refinancing?
Refinancing a loan allows homeowners with a loan to modify the interest rate or length of time to repay the loan. Essentially you are trading one loan for another.
What are some reasons you might want to refinance a loan?
There are several reasons homeowners may decide to refinance a loan. Let’s take a look at the most common reasons:
- Homeowners want to reduce their interest rate on their loan.
With interest rates declining over the last several years, some homeowners may decide to keep their 30 year loan and simply get a lower interest rate. For example, if you have a good credit score and you borrowed $200,000 with an interest rate of 3.782% you might pay $930 per month over 30 years. If your credit score is low and your interest rate is 4.8%, however, you would pay $1,052 to borrow the same amount of money. Unfortunately, that’s $122 more per month and $44,000 more over the life of the loan.
In this example, if you were able to improve your credit score and the available interest rate decreased, you might be able to save a substantial amount of money by refinancing your 30-year mortgage.
- The ability to convert your mortgage from a 30-year to 15-year mortgage.
Another reason you might want to convert your loan is because you want to pay your mortgage off in 15 years rather than 30 years. Although this will increase your monthly mortgage payments, it’s likely to save thousands of dollars in interest. It might also allow you to eliminate your mortgage payment before you reach retirement age.
- Convert your adjustable rate mortgage (ARM) to a fixed rate mortgage.
Another common reason to refinance is to avoid a substantial increase in your interest rate when the adjustable mortgage rate period is over. Refinancing your ARM may increase your monthly payments, but at least you can eliminate the risk of high interest rates in the future.
- Refinancing to take out equity in your home.
Finally, homeowners also refinance home mortgages to take equity out of their homes. While this might seem like a good idea, it’s generally not financially sound. In fact, tapping into your home’s equity may be just another way to continue to live beyond your means.
Even if your intentions are to use the money to repay debts, many people who do this continue to generate high-interest debt on credit cards or other large purchases and spend unnecessary money on wasted refinancing fees while still losing equity in their home.
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