What Is Refinancing?
Refinancing refers to the process of taking out a new loan to pay off old debts. Refinancing is particularly common with mortgages because of their long repayment terms. The ability to adjust the terms of the old mortgage to a new loan -- the refinance loan -- that might fit your budget better is an attractive option for many consumers.
Changing Interest Rates
You might choose to refinance a loan to get a lower interest rate than the rate you are currently paying. This might be because interest rates have fallen since you took out the loan or because your credit worthiness has improved. You might also want to switch from a fixed rate loan to a variable rate loan, if you think interest rates are going to drop soon, or vice versa if you expect interest rates to rise. Finally, the Federal Reserve Board notes that you might want to change how long you're going to take to pay off your loan. For example, if you can make larger payments and want your mortgage gone faster, you might refinance from a mortgage with 25 years remaining to a mortgage with a term of 15 years.
Other times, refinancing allows you to borrow more money using the same collateral, such as your home, typically called a cash-out refinance. You may be able to tap extra equity in your home that you've built up by paying down your old mortgage or because the value of your home has increased. For example, say your bank lets you borrow up to 80 percent of your home's value. If you took out $80,000 when the home was worth $100,000, but have paid it down to $65,000 and your home is now worth $120,000, you could borrow an additional $31,000 with a cash-out refinance.
Costs of Refinancing
Just because interest rates go down a bit doesn't guarantee it's worth it to refinance. Even if you roll the closing costs into the new loan, that's still additional money you must repay. For example, say you owe $80,000 on your mortgage and you refinance with $2,500 of closing costs. If you roll those costs into the new mortgage, you'll owe $82,500 after you're finished. And, before taking out a mortgage refinance loan, check your existing lender to make sure you won't get hit with a prepayment penalty.
When Refinancing Is Worth the Cost
A quick rule of thumb for figuring if a refinance is going to save you money is to divided the amount you save on your monthly payments by the amount of time you expect to keep the new loan. For example, say your current mortgage payment is $960 per month, and you could refinance to a $900 per month payment -- a $60 savings. If the refinance costs you $2,000, you would have to expect to keep the new mortgage for at least 34 months for it to save you money.