Should You Refinance Your Mortgage? A Homeowner’s Guide to HELOCs and More

July 2, 2019

Refinancing a mortgage can be a great way for homeowners to save some money. But beware—make a wrong move when you refinance a loan, and you could easily get in over your head. That’s why we highlight here the right (and wrong) ways to refinance your mortgage loan.

What is home equity?

Your home equity is the current market value of your home, minus the amount you owe on your mortgage. While paying down your mortgage loan will decrease your debt and increase your home equity, the value of your home can rise (or fall) and increase (or decrease) your home equity, too. (Here’s how you can get an estimate of how much your home is worth.)

What is a refi?

When you refinance your mortgage, you’re essentially applying for a new loan. Once again, you’ll be subject to complete documentation and verification of your income, assets, debt-to-income ratio, credit score, and job history. Your real estate property will need to appraise for enough value to support the mortgage refinance, and you’ll have to show that you can afford the new monthly payments on the mortgage.

You will also need to either pay closing costs on the loan, which run anywhere from 2% to 7% of the amount of the mortgage, or opt for a no-cost refinance, where your lender covers the closing costs but you get a slightly higher interest rate on your new loan.

A mortgage refinance can be for the amount you currently owe on your mortgage, or it can be for more or less money. If you have extra cash and want to reduce your mortgage balance, putting money with your refinance is a good idea. The lower your new loan amount, the less you’ll pay in loan origination fees and interest. On the other hand, if you get a cash-out refinance, you can get a check at closing.

Whether you use the same lender for a mortgage refinance is entirely up to you, says Jordan Dobbs, a loan officer at Washington First Mortgage in Rockville, MD. Even if you were happy with your current mortgage lender, it could be beneficial to shop around and compare your loan options with different lenders.

4 reasons refinancing a mortgage can work

There are several things that could prompt you to refinance your loan:

  1. To get a lower interest rate. Many people decide to refinance a mortgage when mortgage rates are lower so that they can lower their monthly payments and, consequently, pay less in interest over the life of the loan. You may also qualify for a lower interest rate now than you did when you took out your mortgage (e.g., if your credit score has improved). If that’s the case, you’d want to look at your potential closing costs and calculate your break-even point to determine whether it makes sense to refinance, since you’re also resetting the clock in terms of the life of your mortgage. You can use realtor.com®’s refinance calculator to crunch the numbers of your own mortgage and see how much you’ll save on your monthly mortgage payments if you refinance at a lower interest rate. (One rule of thumb says that if your interest rate is more than 1% above current mortgage rates, deciding to refinance is a smart move.)
  2. To get a different type of mortgage. Some borrowers want to refinance an adjustable-rate mortgage into a fixed-rate loan, while others want to reduce their loan term from a 30-year loan to a 10-, 15-, or 20-year loan in order to pay it off faster and save money in interest payments over the long haul.
  3. To stop paying private mortgage insurance (PMI). If you didn’t have enough cash to make a 20% down payment when you purchased your home, your lender likely required you to get mortgage insurance—a monthly premium that typically costs between 0.3% and 1.15% of your home loan and is included in your monthly payment. If you refinance to a loan without mortgage insurance, you can save hundreds of dollars each month in your mortgage payment, but you’ll need to have at least 20% equity in your home to qualify, says Dobbs.
  4. To tap into the home’s equity. People also refinance a loan because they want to take cash out of their real estate, which is often done to make home improvements, pay for college, consolidate debt, or make a down payment on a second home. If you decide to go that route, you can choose between a cash-out refi and a home equity line of credit (or HELOC). Be aware that a cash-out refinance increases the size of your loan amount over your previous balance on your original mortgage loan. A one-time mortgage refinance may be a good strategic move if the monthly payment does not adversely affect your cash flow and financial goals. However, repeated mortgage refinances every few years will put you further in debt and extend your loan term, making it difficult to ever pay off your loan balance.

What’s the difference between a home equity loan and a HELOC?

Although these two loan products sound similar, they’re significantly different. With a home equity loan, you decide how much you want to borrow against your real estate and then make monthly payments, similar to a regular mortgage. Thus, with a home equity loan you avoid the temptation to overspend, because you’ll be borrowing a set amount. Also, because the interest rate is usually fixed, you have peace of mind knowing that the payments will remain the same.

A home equity line of credit, or HELOC, meanwhile, functions more like a credit card, because it allows you to borrow up to a certain amount (typically 75% to 85% of the appraised value of the real estate, minus what you still owe) on an as-needed basis over the term of the loan (usually five to 20 years). In fact, your lender will actually issue you a plastic card that you can use to access the money easily. A HELOC works well if you want to borrow money but don’t know exactly how much you’ll need (a common conundrum when making home improvements).

The main drawback to HELOCs? Unlike with home equity loans, interest rates on HELOCs are variable, which means they fluctuate depending on market conditions. And while many lenders offer a low “introduction” rate, it lasts only for a matter of months; after that, the interest rates will adjust—and continue to readjust—which could create problems if you don’t prepare for the potentially higher payments. So be sure to weigh these pros and cons before you start chipping away at the real estate equity you’ve gained.

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