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The pros and cons of refinancing

When should you refinance? Here’s what you need to consider before making a decision.

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You bought into your first home a few years ago and you couldn’t be happier. Then, you’re listening to the news one day on your way home from work and hear interest rates are at the lowest level they’ve been in the last five years. With your loan fresh in your mind, you check your mortgage agreement and find rates have indeed dropped since you got your loan.

It’s time to consider the pros and cons of refinancing.

Interest rate reduction

If your mortgage is relatively young, getting into a new mortgage with a lower interest rate could save you money. Given the dollar amounts mortgages typically entail, along with the length of time they generally run, a reduction of two percent could mean huge savings. For example, if you have a $250,000 mortgage at six percent and you can get it reduced to four percent, you’ll save nearly $300 per month.

Going from adjustable to fixed

Adjustable rate mortgages come with lower introductory interest rates, because the bank is counting on interest rates to rise over time—and along with them, the amount of money you’ll pay for the loan.

In essence, you’re betting interest rates will stay low and banks are betting they’ll increase. Since you’re talking about a period of 15 to 30 years, the odds are in favor of the bank.

However, if interest rates drop significantly after you take that adjustable, and you can refinance into a fixed at the same (or better still) a lower rate, you’ll make out huge in the long run.

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Access your equity

As time goes on, property values tend to rise, and you’ll pay your mortgage down. Eventually, you’ll hit a point at which your home is worth more than you owe. The difference between the property’s value and your outstanding balance is your equity.

Refinancing could give you access to that money, which you can then use to pay off other debts, fix up your home, invest in a rental property or any number of things. If you’re having trouble clearing up credit card debt, refinancing to pay off them off might be a good idea too.

However, before you tap into your home equity for this purpose, consult with a firm like Freedom Debt Relief to explore other ways to clear up debt.

Still, all of the above can safely fall into the “Pros” column.

Resetting the clock

Let’s take a moment to understand how repaying a mortgage works. It’s front-loaded. In the early years of your mortgage the vast majority of your payments go to satisfy the interest on the loan. In other words, the bank takes its interest payments first.

If you check it out, even after you’ve made your twelfth payment, your principal amount will be barely reduced. As you progress further into the term of the loan, more of your monthly payment goes to reducing the principal amount of the loan.

refinancing
Refinancing counts as a new loan, which sets you back to square one. (Photo by fizkes via Shutterstock)

However, refinancing counts as a new loan, which sets you back to square one. If you’ve reached the point at which the majority of your monthly payment is going to principal, refinancing might not make sense. You’ll be that much farther away from paying off the loan—and you’ll start making interest payments all over again.

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Basically, you’ll be borrowing your own money and paying the bank interest to loan it to you. Like so many things financial institutions do, what looks good for you is even better for them.

While this is the most significant con you’ll encounter when considering a refinance, you’ll also pay closing costs, loan origination fees, appraisal fees and processing fees. As you’re considering the pros and cons of refinancing, take all of the numbers into consideration to be sure what looks like a good deal now will be a good deal in the long run. Focusing on the short term is a surefire way to come up on the losing end of a refinancing deal.

(Featured image by William Potter via Shutterstock)

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