Home refinancing has the power to completely transform your finances for the better, but it’s not a suitable option for every homeowner. To make matters worse, some people fundamentally misunderstand what home refinancing is, and how it works. So what exactly is this financial maneuver, and under which conditions should you refinance your home?

How Home Refinancing Works

Let’s start with a primer on home refinancing. Just as there are a large number of different mortgages available, there are many home refinancing loans to choose from. However, the basics are almost always the same.

Basically, the idea is to pay off your current mortgage, using funding from a new loan—the “refinancing” component. Practically speaking, the new loan will serve as a replacement for the old loan. As a homeowner, you can count on making consistent monthly payments using new calculations, which typically depend on a new amount of borrowed principal, a new interest rate, and new terms.

Motivations for Refinancing a Home

There are several situations that could prompt you to seek the help of home refinancing, but these are some of the most common:

• The possibility of a lower interest rate. The first and most obvious way refinancing could improve your finances is the possibility of getting a lower interest rate. As you’re likely aware, your interest rate applies to your borrowed principal, so if you’re paying a 5 percent interest rate on a loan of $100,000, you’ll be paying $5,000 per year in interest alone. If you could somehow get a nearly identical loan with an interest rate of 4 percent, you could reduce that to $4,000 per year in interest, ultimately saving $1,000 per year with no other changes to your home or your situation. Depending on the interest rate you signed up for and the current interest rates available, you may be able to save money.
• Converting from variable to fixed interest rates. It’s also possible that your original loan came with a variable interest rate. Generally, fixed interest rate loans are considered superior, because they’re more reliable. If you sign up for a variable interest rate loan, you might get a more favorable interest rate to start, but that rate can increase in line with rate increases across the board; in other words, you might be vulnerable to rate increases over the life of your loan. By refinancing, you may be able to convert your variable interest rate into a fixed rate, ultimately resulting in more stable payments and more favorable terms.
• Reducing or lengthening the term of the loan. Most home loans are set for 15-year or 30-year terms. Payments for 15-year terms are much higher each month, since you’ll be paying the home off in half the time. The flip side is that you’ll pay far less interest over the lifetime of the loan. There are pros and cons to each approach, but in the middle of your loan’s duration, you may find yourself regretting your decision. Home refinancing may allow you to reduce or lengthen the term of the loan.
• Restructuring debt. In some cases, people choose to refinance their home loans as a way to restructure their debt. For example, let’s say they’re carrying tens of thousands of dollars in high-interest credit card debt, but they have a lot of equity in the home. This person may be able to refinance the home, getting access to more cash they can use to pay off their credit cards. The downside is they’ll have more home debt, with higher monthly mortgage payments, but in many cases, this still a preferable option.
• Freeing up cash. Similarly, homeowners may be interested in refinancing as a way to free up cash. Depending on how you refinance, you may be able to get access to more liquid assets—which could be vital in a financial emergency.

Is It a Good Idea to Refinance Your Home?

So what’s the bottom line? Is it a good idea to refinance your home?

Ask yourself these questions:

• Can your rate be lowered? Could you reduce the amount of interest you pay every year?
• Are you stuck with an adjustable rate? Generally speaking, fixed rates are more advantageous for homeowners. Can you make the transition?
• Do you need extra money? Additional cash could relieve financial pressure, or help you pay off higher-interest rate debt.
• Do you need different terms? Would you prefer to pay off your home sooner, or face lower monthly payments?

For some homeowners, home refinancing offers negligible benefits, or may even put you in a worse position. But for others, home refinancing can put you in a better financial situation. It all depends on your current situation and your future goals.