Should I refinance my mortgage?
With inflation running hotter than it has in years, you’re probably looking everywhere for opportunities to trim your monthly expenses. If you own your home, you don’t have to look far to find one of the biggest. You might be sitting in it right now, in fact.
If today’s mortgage interest rates are lower than the rate on your current mortgage, refinancing your home loan could reduce your monthly payment and free up some space in your budget. Depending on the size of your outstanding balance and the difference between those two rates, refinancing could save you dozens or even hundreds of dollars every month.
But does the fact that refinancing your mortgage makes sense on paper mean you should actually do it?
Should I Refinance My Mortgage Loan?
The short answer is: It depends.
If you’re confident you can save more over the life of your refinanced loan than you’ll pay in closing costs and other incidental expenses, refinancing makes sense from a financial standpoint.
However, the comparison between your original loan and your new loan might not be apples-to-apples. The new loan could have a longer term or include a cash-out component.
If this is the case, the benefits of refinancing must outweigh the costs. Those benefits might include a lower monthly payment, a lower interest rate, or a faster payoff time.
Before you can determine if refinancing makes sense, you must learn more about why you’d want to refinance your mortgage in the first place. You also need to consider how your credit score, income, and other factors affect your chances of approval and your refinance loan’s interest rate.
But even if refinancing your mortgage sounds appealing, your answer to the question of whether you should is still only a tentative yes.
So don’t call your loan officer just yet. First, understand what each refinancing goal really entails, how your specific circumstances could affect your approval chances and refinance loan rate, and whether it’s the right time to do it.
Reasons to Refinance Your Home Loan
Before moving ahead with your refinance application, determine whether it’s worth the trouble. Your first step is to gain a detailed understanding of each reason for refinancing.
Get a Lower Interest Rate
Getting a lower interest rate is one of the most common reasons to refinance a mortgage.
For some borrowers, getting a lower rate is more likely when mortgage rates are low. But if your credit score, income, and debt-to-income ratio have improved since you bought your house and your current loan balance is less than 80% of the value of your home, you’re likely to qualify for a lower interest rate if rates are lower than they were when you first got your mortgage.
In contrast, if your income or credit score has fallen or your debt-to-income ratio has increased, you might have trouble qualifying for a better rate even if rates have fallen.
Lower Your Monthly Payment
Every mortgage payment reduces your loan balance — probably not as quickly as you’d like, but every little bit helps.
If rates have also fallen in the meantime, refinancing that smaller balance into a loan with the same term is likely to result in a lower monthly payment. But the combination of closing and prepayment costs makes it crucial to think twice about refinancing to a rate less than 1.5% lower than the original mortgage if the goal is to lower the monthly payment.
If you’re really set on lowering your monthly payment, you can apply for a longer-term refinance loan. It’s an even more reliable way to lower your payment, even if rates haven’t fallen much — and maybe even if they’ve risen.
For instance, if you’ve been paying your 30-year mortgage for eight years and have 22 years left on the term, refinancing the remaining balance into a new 30-year loan spreads out the loan’s payments over eight more years. That probably achieves a lower payment unless interest rates have really spiked.
But that comes at a cost. You’ll pay more interest over the life of the loan and take longer to own your home free and clear, which can have significant financial benefits as you near retirement.
Get a Shorter Loan Term
You can also move in the other direction — refinancing your current mortgage into a new loan with a shorter term.
It has two potential benefits:
- Reducing the total amount you pay on your mortgage and, thus, your total cost of homeownership
- Accelerating your progress toward paying off your mortgage — and free-and-clear homeownership
If you refinance that same remaining 22 years of your 30-year mortgage into a 15-year loan, you shave seven years off your total repayment time.
This shorter-term loan is likely to have a lower interest rate than the 30-year term because it sits on the lender’s books for less time. That could magnify the potential savings.
Once you own your home free and clear, you’ll drop what’s likely one of your household budget’s biggest line items: your monthly principal and interest payment. You’ll still owe property taxes, homeowners insurance premiums, and possibly homeowners association dues, but your monthly housing payment will still be a lot lower.
The biggest downside of a shorter loan term is a higher monthly payment. If your budget has limited room to absorb a higher payment, refinancing into a shorter loan term isn’t feasible unless you can find expenses to cut or a means to earn extra income over the long term.
Tap Into Your Home’s Equity
The longer you live in your home and pay your mortgage, the easier it becomes to tap your home’s equity so long as your home’s market value has remained stable or increased.
A refinance loan that allows you to tap the equity in your home is known as a cash-out refinance. You can use the cash to finance a home improvement or repair project, consolidate higher-interest debt, or cover major life expenses like college tuition.
Some lenders issue cash-out refinance loans up to 85% of the appraised home value, but most cap the principal at 80%. To figure out roughly how much cash you can get in a cash-out refinance, you must:
- Estimate your home’s current market value using publicly available information from Zillow or Redfin
- Subtract 20% of that value
- Subtract the balance remaining on your original mortgage
For example, let’s say your home’s estimated value is $500,000. Subtracting 20% of $500,000 — which is $100,000 — leaves you with $400,000.
If you have $300,000 remaining on your first mortgage, the difference between the maximum you can borrow and the amount needed to pay off the first mortgage is $100,000. That means you can get up to $100,000 from a cash-out refinance loan.
Get Rid of Private Mortgage Insurance
If you’re paying private mortgage insurance, refinancing your loan could eliminate a significant line item in your total housing payment.
Private mortgage insurance applies to conventional mortgage loans with down payments under 20% of the purchase price. Because it automatically goes away once the amount you owe on your mortgage drops below 78% of the home’s value, many homeowners simply wait it out.
But if you put a lot less than 20% down, that wait will last years. If the value of your home has significantly risen since you bought it, and the amount you owe is comfortably below 80% of the home’s value, refinancing eliminates private mortgage insurance without the wait.
Get Out of an FHA Loan
If your credit has improved since you bought your house, any reason for refinancing a conventional mortgage loan also applies to refinancing an FHA loan — that is, a loan backed by the U.S. Federal Housing Administration.
But one common reason is to get rid of the FHA mortgage insurance. Annual FHA mortgage premiums can exceed 1% of the loan principal, depending on the term, issue date, and original down payment. That can quickly get expensive, but there’s good news.
You can get rid of annual FHA mortgage insurance payments by refinancing into a conventional loan once you’ve achieved at least 20% equity in your home. That eliminates mortgage insurance premiums moving forward.
Understand that refinancing from FHA to conventional won’t retroactively eliminate the 1.75% upfront mortgage insurance premium charged on all FHA loans. If you rolled that balance into your original loan’s principal, it carries over to your refinanced loan.
Switch From an Adjustable-Rate Mortgage to a Fixed-Rate Mortgage
An adjustable-rate mortgage seems like a good deal at first. During the initial term, typically five to seven years, the interest rate remains fixed at a very low rate. Often, this rate is lower than refinance rates on 30-year fixed-rate mortgages.
The reckoning comes at the end of the initial term when the rate is eligible to adjust for the first time. If interest rates have increased in the meantime, the rate increases, sometimes by several percentage points. It can increase or decrease each year thereafter, depending on what’s happening with interest rates.
Although caps on rate and payment increases provide some protection for borrowers, adjustable-rate increases can still be difficult for household budgets to absorb. That’s why many adjustable-rate mortgage borrowers refinance into conventional fixed-rate mortgage loans before the first rate increase.
Even accounting for a prepayment penalty, this move could dramatically reduce your borrowing costs when rates are high. It also guarantees predictability around future mortgage payments, which could be just as important.
A cash-out refinance is a low-cost way to consolidate higher-interest debts, such as credit card balances. The interest rate on your cash-out refinance loan is certain to be lower than your credit cards’ interest rates, saving you a boatload on interest.
You can also use a cash-out refinance loan to consolidate a home equity loan or line of credit balance into your primary mortgage, eliminating the extra monthly payment and potentially saving some money.
Refinance a Jumbo Loan Into a Conventional Loan
Because the federally backed home mortgage companies Fannie Mae and Freddie Mac don’t guarantee them, nonconforming jumbo loans are riskier for lenders. As a result, they often carry higher interest rates than conforming loans. “Conforming” just means they conform to Fannie Mae or Freddie Mac standards.
If your jumbo loan’s remaining balance is lower than the conforming loan limit of about $650,000 — and up to 50% higher in expensive real estate markets — you could significantly reduce your interest rate and lifetime interest costs by refinancing into a conventional loan.
Remember that your new loan must remain below the conforming loan limit after accounting for any rolled-in closing costs.
Drop a Former Spouse or Partner From the Title
Refinancing to remove a former partner’s name from your mortgage is more of a practical matter than a money-saving move.
However, it can certainly reduce your monthly mortgage payment and lifetime borrowing costs if rates have fallen since you bought your house. Either way, it is one more cost of getting divorced.
If your lender allows it, you might be able to remove your former spouse or partner from the mortgage without refinancing. That requires a loan assumption or modification. These processes aren’t as costly or involved as refinancing and end up in the same place: with you, and you alone, on the title.
Unfortunately, many lenders don’t allow loan assumptions or modifications. So if you need to refinance your mortgage to drop your former spouse or partner from the title, do so as soon as the signatures on the divorce papers are dry.
The tricky part may be that you need to qualify for the loan on your own with no help from your former spouse’s credit score or income, which may have factored into the original mortgage. If you expect that to be difficult, get a co-signer or sell the home.
Reasons Not to Refinance Your Home Loan
Even if you can find a reason — or several — to refinance, consider the potential downsides. In certain circumstances, it might not be worth the effort.
You Might Not Break Even
Refinancing to remove a former spouse or partner from the title is what it is. You might have to do it even if it’ll cost you.
But if you’re refinancing for financial reasons, it doesn’t make sense to move forward if you won’t break even.
To calculate your likely breakeven point before applying, use a mortgage refinance calculator.
Find your expected monthly principal and interest payment by entering your refinance loan’s interest rate, term, and principal. Use information from your current mortgage servicer to add your monthly property tax, property insurance, private mortgage insurance, and homeowners association fees.
Subtract any monthly costs that don’t apply to your refinance loan, such as your annual FHA mortgage insurance premium. That gives your refinance loan’s expected total monthly payment.
Next, subtract the result from your current mortgage’s monthly payment. This number is how much you expect to save each month by refinancing.
Finally, divide your refinance loan’s total closing costs by your expected monthly savings and round up to the nearest whole number.
That’s the number of months it’ll take you to break even on your refinance loan, assuming no changes to your original loan’s interest rate or other components of your monthly payment.
If your breakeven point is sooner than your original loan’s expected payoff date or the earliest date on which you plan to sell your home, you can save money in the long run by refinancing. The longer you remain in your home, the more you can save.
Your Savings Will Be Minimal
Refinancing might not make sense if you just break even on the loan. The process itself is time-consuming and grates on the nerves.
Before going through with your refinance, figure out how much you need to save to justify the effort. Maybe that means lowering your monthly payment by $100, $200, or $500. Only you know the answer.
You Can’t Afford the Closing Costs
A lower interest rate on a smaller starting balance doesn’t guarantee a lower monthly payment. Refinance loans always carry closing costs.
Closing costs on refinance loans typically range from 2% to 5%. That’s a pretty broad span, and it’s hard to get a good idea of where your closing costs will fall until you apply for your loan. Even then, the exact amount will likely vary right up until you close.
Still, you can get a sense of how much your loan will cost before you apply by adding up the potential closing costs:
- An origination fee as high as 1.5% of the loan value
- An appraisal fee not likely to exceed $500
- Title insurance premiums likely to range between $400 and $1,000 — possibly lower for a modified version of the original title insurance policy
- A settlement fee not likely to exceed $1,000
- Discounted prepaid interest, or discount points — each point costs 1% of the loan value and reduces the interest rate by 0.25%
These costs can really add up. And rolling your loan’s closing costs into the loan principal, as is customary on a refinance, increases the balance that earns interest. If the starting balance wasn’t much lower than your first mortgage’s balance, that could result in a larger loan.
If your original mortgage is less than five years old, your refinance could also trigger a prepayment penalty — most likely under 3% but up to 5% of the balance in some cases. That’s a big hit.
The combination of closing and prepayment costs is why experts recommend thinking twice about refinancing to a rate less than 1.5% lower than the original mortgage if the goal is to lower the monthly payment.
Ensure you can afford the closing costs (and prepayment penalty) before moving forward with the refinance.
You’ll Be Moving Soon
It’s worth reiterating that refinancing doesn’t make financial sense if you plan to sell your home before you break even. There’s no point in going through the trouble of refinancing just to lose money on the deal.
The calculation changes if you plan to move but can afford to rent your current home instead of sell. You’ll benefit from your refinance loan’s lower monthly payment as long as you own the property, which could be years or decades after you move.
You Need to Improve Your Credit Score
You won’t qualify for the best available interest rates if your credit score has taken a hit since you bought your home. That could reduce or eliminate the financial benefit of refinancing, though you won’t know for sure until you calculate your monthly payment.
If it turns out that you won’t save money because you don’t qualify for a good rate on your refinance loan, all is not lost. Work on improving your credit score, keep close tabs on it, and be ready to reapply when it’s in better shape.
Verdict: Is Mortgage Refinancing Right for You?
Still not sure whether it makes sense to refinance your mortgage? Review when refinancing is probably a good idea and when it’s smarter to hold off.
You Should Refinance Your Mortgage If…
There are many good reasons to refinance your mortgage. Generally, refinancing makes sense only if it benefits you in the long run, including these scenarios.
- You Can Lower Your Monthly Payment. If you can significantly reduce your monthly payment by refinancing, your budget thanks you in advance.
- You Want to Pay Off Your Mortgage Faster. Refinancing into a shorter-term loan might raise your monthly payment, but you also pay less interest over the life of the loan and own your home free and clear that much sooner.
- You Want to Get Rid of Mortgage Insurance. If you’re currently paying private or FHA mortgage insurance and your home’s value has increased since you bought it, refinancing could eliminate this unwelcome part of your monthly housing payment.
- You Want to Get Out of an FHA Loan. If your original mortgage was an FHA home loan and you want to convert it to a conventional mortgage, you need to refinance.
- You Want to Avoid an Upward Rate Adjustment. If you currently have an adjustable-rate mortgage and rates have increased since you bought your home, refinancing into a fixed-rate mortgage could blunt the budgetary impact.
- You Need Low-Cost Financing. Refinancing your mortgage allows you to tap your home’s equity to achieve any number of big-time financial goals, such as consolidating debt, tackling a home improvement project, or paying off student loans.
- You Have a Nonfinancial Objective. Sometimes, you have to refinance, even if it’s not in your best financial interest. One common circumstance is refinancing to remove a former spouse from the loan because they no longer own the house.
You Should Think Twice About Refinancing If…
Refinancing your mortgage doesn’t always make sense. Think twice if one of the following applies to your situation.
- You Won’t Save Any Money. Nonfinancial objectives aside, refinancing usually isn’t a good idea if it won’t save you money by reducing your monthly payment or lifetime interest expense.
- You Plan to Sell Before Breaking Even. Every refinance loan has a breakeven point. Refinancing doesn’t make sense financially if you expect to sell the house before reaching that point.
- You Have Bad Credit. If your credit has declined since you got your first mortgage, you might not qualify for a refinance loan at all. If you do, it might not save you any money. If you can, wait until your credit is in better shape before applying.
If you have a clear refinancing goal in mind and expect to remain in your home long enough to break even on your new mortgage loan, refinancing your current loan is probably the right move.
Even if you don’t expect to break even on your refinance loan, it might make sense if you have another goal in mind, such as financing a major home improvement project.
But it’s best to ensure you fully understand what the mortgage refinancing process entails. Applying for a loan as big as this isn’t for the faint of heart.