Types of Refinancing

Refinance loans generally come in two types: a rate-and-term loan and a cash-out refinance. In a rate-and-term loan, you get a lower interest rate on your loan balance, and possibly a longer or shorter repayment term. In a cash-out refinancing, you refinance your mortgage for more than you owe on it so you have a readily accessible chunk of cash.

Why Refinance?

The reasons that people refinance with a cash-out loan include paying off debts such as those on a credit card, to remodel or renovate their property, or to pay for expenses such as college tuition. A rate-and-term refinance often occurs when homeowners want to switch from an adjustable rate to a fixed rate or want to get rid of mortgage insurance.

Refinancing should solve a problem or save you money. If it does neither, you probably shouldn’t refinance. Such scenarios include if you’re refinancing to buy an expensive new TV and furniture—don’t refinance! You also don’t want to refinance every few years, because the potential cost savings just don’t add up.

Be careful when you decide to refinance for remodeling and renovation purposes. Determine how much of that investment adds to the value of your home. You’re more likely to benefit from maintenance-type work such as installing new siding and a new roof versus putting in a new bathroom. Refinancing to pay for your college education can be worth the risk as well, if the education leads to a new job that multiplies your income a few years down the road.

If your new loan nets you a longer term, you could be sacrificing short-term savings for longer-term payments. Neither scenario is right or wrong; just be aware of what is going on. And in some situations, you’re saving money in the long term as well. For instance, say you’ve been paying $950 for the past five years. If you don’t refinance, your payments equal $285,000 during the next 25 years. If you refinance so that you’re paying $700 a month for 30 years, your payments equal $252,000, which does save you money in both the long and short terms.

Other potential costs that come with refinancing include prepayment penalties on your new loan. Agreeing to such terms is a bad idea; try to find a lender that won’t impose such penalties on you. Also, if the worth of your home has decreased, you may need to take on private mortgage insurance. Lenders typically require PMI if you have less than 20 percent equity in your home. The thinking goes that the more you have invested, the higher chance you’ll make timely payments.

In sum, if you refinance strategically, you have a good chance of saving money. Avoid refinancing every few years and in situations in which the life of your loan would be drastically extended. Do not take out loans that carry prepayment penalties, and if you want to refinance to pay for a new TV, new furniture and the like, you’re better off saving a little bit each month instead of putting your home at risk.