Refinancing your mortgage – it sounds scary at first! But having the option to refinance can actually be a good thing. In fact, refinancing your mortgage can be a great financial tool – one that helps you accomplish financial goals at a low interest rate – but be careful! A refinance leaves you on the hook to pay an expensive prepayment penalty, meaning that it might cost you more money than you’d save.
Let’s take a look at three examples where refinancing is the right option, with our test subject Molly and her $350,000 home.
1. Taking Advantage of Low Interest Rates
Refinancing to take advantage of low interest rates might be a great way to save money, but it’s extremely important to be aware of the prepayment penalty you’ll have to pay upfront to get that rate. For example, Molly has a $225,000 mortgage on a home that is valued at $350,000. She’s 3 years into a 5-year fixed rate term at 5.00%. Molly is considering refinancing another 5-year term at a lower interest rate of 3.50%.
At first glance, this seems like a great idea! Saving 1.50% on a $225,000 mortgage means Molly would save $6,750 in interest (1.50% x $225,000 x 2 years). However, by using thismortgage refinance calculator and factoring in her prepayment penalty of $2,813, we can see that Molly would only save $3,937 after she pays the penalty to break her mortgage term early. Refinancing will still save Molly money, but the savings aren’t nearly as good as she first anticipated.
2. Accessing Equity in Your Home
Refinancing your mortgage can allow you to access up to 80% of your home’s value. By refinancing, you can access your equity and use those funds to renovate your home, send a child to post-secondary or buy a second property, without having to sell your home or take on a second loan at a higher interest rate.
For example, if Molly wanted to access the equity in her home to renovate her kitchen, she could access 80% of the value of her home, minus the value of her outstanding mortgage, for a total of $55,000 ($350,000 x 80% – $225,000). Her new mortgage would be $280,000 ($225,000 + $55,000), and her payments would decrease from $1,745 to $1,398 due to the new term and lower interest rate. She’d still have to pay a refinancing penalty fee of $2,813, which would cut into that $55,000, but she’d have access to that equity at a much lower interest rate than if she’d taken out a traditional loan.
3. Consolidating Debt
Finally, one of the most popular reasons to refinance a mortgage is to consolidate debt. Mortgages are one of the least costly forms of debt available, with lower interest rates than a credit card or even a personal line of credit.
For example, if Molly wanted to pay off $20,000 of credit card debt that had an interest rate of 19.00%, she could refinance and use the equity in her home to do so, shifting her high interest consumer debt over to her much lower interest mortgage debt. Don’t forget that Molly would still have to pay a prepayment penalty of $2,813. Her total mortgage amount would also increase to $245,000 ($225,000 + $20,000), but she would save thousands in credit card interest charges.
Costs of Refinancing Your Mortgage
Before you refinance your mortgage, it’s important to calculate the closing costs involved to see if it’s the right choice for you. For starters, you’ll have to pay a prepayment penalty. If you have a fixed rate mortgage, it’s the greater of three months’ interest or the interest rate differential (IRD). If you have a variable rate mortgage, the penalty is just three months’ interest. Either fee could outweigh the savings you would get through a refinance, so it’s important to calculate the penalty before you go through with the refinance.
You may also have to pay a real estate lawyer to conduct another title search, as well as review all documents, register the new mortgage and facilitate the financial transaction. If you have more than $200,000 left on your mortgage, many lenders and brokers will cover this legal expense for you.