When you sign a mortgage and buy an investment property, you are locking yourself into a huge commitment. There are different types of mortgages that give you different degrees of flexibility, but in most cases, the purchase of real estate will be the largest financial commitment that most people will make in their lifetime.
Throughout the term of your mortgage, things can change drastically in your life and in the world around you. The economy will likely see numerous major downturns and upturns which can impact interest rates, employment, and your ability to pay your mortgage. Sometimes, you’ll be doing better off then you were when you signed your mortgage and this can also have an impact on which strategy is best.
For instance, you could come across a large sum of money unexpectedly, inherit money that you were expecting, or get a promotion and a raise at work. It’s not likely, but you could even win the lottery. You could get sick and lose your ability to work, you could get divorced, or you could decide that you want to move somewhere else. The point is that it’s not always practical to be locked into something super long term without any ability to change it.
Refinancing a mortgage can help with some of these things, but not others—that’s just part of life. We’re going to talk about when refinancing your mortgage can be beneficial, when it might not be a great idea, and under which circumstances it will make it worthy of your consideration.
What exactly does refinancing mean?
To put it simply, refinancing means taking out a new loan to pay off your existing loan. In the case of a mortgage, you will take out a new mortgage with different terms than your existing mortgage and you’ll use the new mortgage to pay off your existing mortgage. On the surface, the concept of refinancing is pretty simple, but there’s a lot more nuance to mortgage refinancing to consider before taking out a new loan.
Refinancing gives you the opportunity to do the following:
- Secure a new mortgage with a lower interest rate
- Shorten the term of a mortgage
- Convert a fixed-rate mortgage to an adjustable-rate mortgage
- Invest in a new business or in the markets
- Raise funds for an emergency
- Gain access to cash via your home equity
- Use home equity to pay off other debts
Some of these are good ideas to consider under the right circumstances, whereas others are not recommended at all. Here are some more information about how to tell the difference.
What are the reasons for refinancing your mortgage?
Answering whether or not it’s a good idea to refinance your mortgage has everything to do with your unique scenario. Here are some examples of good reasons to refinance, but some bad reasons that should be avoided, too.
There is a fee associated with refinancing, which is usually a couple or a few percentage points of the principal of the loan. In addition to that, you’ll have to pay other fees again, such as application fees, a title search, and an appraisal.
Refinancing for a lower interest rate
If interest rates have shifted enough and you’re in a fixed-fee mortgage, then take into account the aforementioned fees to calculate whether or not it’s worthwhile for you to refinance.
This is the best, or at least one of the best, reasons to refinance your mortgage because it’s fairly clear-cut, as the money isn’t going towards other debts that can pile up again. You can adapt your mortgage to current conditions and needs. Additionally, it can simply save you money via lower monthly payments, paying off your mortgage sooner, or paying less in interest.
If you’ve decided you want to leave your current investment property sooner than later or you’ve decided that you never want to leave, then either of these decisions can impact the type of mortgage that’s ideal for you and refinancing gives you access to that.
Refinancing for a shorter mortgage term
At some point during the term of your mortgage, you may see interest rates falling. Once they’ve crossed a certain threshold, it becomes irresistible to not refinance. Refinancing at a lower interest rate means that you can keep roughly the same monthly payments, but with less money paid into interest and less interest compounding as time passes, you will be able to pay off your mortgage quite a bit sooner.
With a greater amount of each payment going towards the principal of the loan and less of each monthly payment going towards interest due to the lower interest rate, you can shave time off of your mortgage term and gain full ownership of your investment property sooner.
Again, it’s a matter of calculating what your costs will be (appraisal, title search, application fees) along with what the refinancing charge will be in terms of percentage points. At a certain difference in rates, it becomes a no-brainer to go through this process, but the sweet spot will depend on the terms of your mortgage.
Refinancing credit cards and other debts
There are tools to refinance other debts. Examples include student loans, car payments, credit cards, and more. One of the easiest ways to do that is to consolidate higher-interest debt into a loan with a lower interest. For example, if you have several credit cards at an interest rate of 20% or any other high-interest rate debt, then it’s possible that you could qualify for a loan at a much lower rate. You can transfer your various balances over to this new loan, which moves everything over to one convenient payment at a lower rate.
Refinancing your investment property in order to consolidate credit card debts is not a great idea, though. There are other types of loans that you can use instead—ones that aren’t tied to your housing. Otherwise, you’re taking unsecured debt and exchanging it for debt that could potentially cost you your investment property if you default.
Refinancing to switch between adjustable-rate mortgages or fixed-rate mortgages
When first agreeing to the terms of a mortgage, one of the big decisions to make is whether to get an adjustable-rate mortgage or a fixed-rate mortgage. When choosing between the two, there’s a certain amount of speculation that you’ll have to engage in by guessing where the interest rates could be many, many years in the future. Of course, things don’t always go as planned. The financial markets can take a quick turn along with your own plans and financial needs.
Refinancing gives you the opportunity to switch from an adjustable-rate mortgage to a fixed-rate or to switch from a fixed-rate mortgage to an adjustable-rate mortgage.
If you aren’t planning to stay with your investment property for the long haul, then it can be advantageous to take advantage of lower interest rates with an adjustable-rate mortgage. This will allow you to make smaller monthly payments, which can be useful if you aren’t planning on sticking around until the house is paid off.
If you’re expecting interest rates to rise in coming years and that’s more of a concern to you than smaller monthly payments in the meantime, then it could be worth converting an adjustable-rate into a fixed-rate.
Does refinancing hurt your credit?
If you are frequently applying for new credit and trying to refinance debt on a regular basis, then it’s possible that the hard inquiry into your credit score when you refinance your mortgage could have a negative impact. Generally speaking, however, it shouldn’t cause a dip in your score.
There is a hard credit inquiry as part of the process of refinancing your mortgage, but this process can also help you. If you’ve deemed that it’s the correct financial move to refinance, then this can free up some of your money to pay off other debts and obligations, which can in turn improve your score.
What is a cash out refinancing? What is rate-and-term refinancing?
When you refinance your mortgage by taking out a new mortgage to pay off the previous one, you could take the new mortgage for the amount that you owe on your previous mortgage—thus maintaining your existing equity in the investment property. The goal here is to take advantage of a lower interest rate moving forward. This is called a rate-and-term refinance.
Alternatively, some people choose to do a cash out refinance, which means they’ll secure the new mortgage for the appraised value of the investment property, essentially cashing out the equity they have built in the investment property in exchange for cash that can be used to pay for school, other debts that carry higher rates, or anything else that one may choose to spend the money on. You may also end up with a better rate moving forward.
Cash out refinancing versus home equity loans
Cash out refinances mortgage and home equity loans aren’t quite the same thing. With a cash out refinancing, you’re paying off the previous mortgage and then entering into a new one. The new one is used to pay the previous one. Then, you abandon the terms of the previous mortgage and adopt the terms of the new one. If you’re able to get a new loan with better terms, then this is worthwhile.
With a home equity loan, you are keeping the initial mortgage on the property and taking out a second mortgage on top of that. The rates are usually higher on a second mortgage compared to the first one, but a home equity loan is still often less expensive than refinancing. The first mortgage takes precedence over the second one, which is why the second one will usually cost more.
Is refinancing a good idea?
If you’re refinancing for the right reasons, then it can be a brilliant financial move. The right reasons include:
- When it helps you build equity in your investment property faster
- When it isn’t being used as a band-aid for an underlying financial problem
- When it helps you reduce your monthly mortgage payment
- When it reduces the overall term of your mortgage loan
Otherwise, it’s generally not a great idea to refinance if it’s being used for:
- Something risky like taking advantage of a “hot stock tip”
- To pay off unsecured debt like credit cards
- To turn unsecured debt into debt that is secured against your investment property
- When you aren’t getting advantageous rates or terms
Having said that, there are situations where paying off debt with equity in your investment property that you unlock via a cash out refinance ends up being a good strategy. That would be the case if it’s executed correctly and under the right circumstances.