Should You Refinance Your Mortgage? When It Makes Sense and When It Doesn't
Refinancing could lower your monthly payments, help you pay off your mortgage faster or unlock home equity. But breaking even takes time after upfront costs. Here's how to decide if the benefits outweigh the costs.
Refinancing your mortgage can help you lower your monthly payments, pay off your loan faster or tap into your home's equity. It can also be a way to eliminate private mortgage insurance (PMI) or switch from an adjustable-rate mortgage to a fixed-rate loan.
But refinancing isn't always the right financial move. Closing costs, loan terms and your long-term goals all play a role in determining whether the potential savings outweigh the expense.
Here's how mortgage refinancing works, when it makes sense and what to consider before replacing your current loan.
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How refinancing a mortgage works
Refinancing a mortgage works by replacing your current mortgage loan with a new one, preferably with better terms, a lower interest rate and new (hopefully lower) monthly payments. When you refinance, you usually pay closing costs and fees.
You won't receive money from the loan unless you're doing a cash-out refinance. Instead, your lender will use the loan amount to pay off your existing mortgage. After closing, you’ll start making monthly payments on the new loan.
For example, if you've paid five years on a 30-year mortgage and refinance into a 15-year loan, you'll have 15 years of payments remaining instead of 25. Although refinancing starts a new loan term, choosing a shorter repayment period can help you pay off your home faster and potentially save thousands in interest.
How much does it cost to refinance a mortgage?
Refinancing your mortgage comes with many of the same expenses as taking out your original home loan, including lender fees, appraisal costs and other closing costs.
Refinancing costs can range from 3% to 6% of the new loan amount, according to the Federal Reserve. For example, refinancing a $350,000 mortgage could cost between $10,500 and $21,000. However, fees vary by lender, loan type and location, so it pays to shop around and compare offers.
Before refinancing, calculate your break-even point, or how long it will take for your monthly savings to cover the closing costs. For example, if refinancing costs $6,000 and saves you $200 per month, it would take 30 months to recover those expenses.
If you plan to sell your home before reaching that point, refinancing may not be worth the cost. And while some lenders offer no-closing-cost refinancing, you may end up paying more through a higher interest rate or a larger loan balance.
Which type of mortgage refinance is right for you?
Rate and term refinance
Rate and term refinancing, which lets you change the interest rate and terms of your existing mortgage, is considered the most common type of refinancing. Your mortgage balance won't change, but your monthly payment may drop because of a lower interest rate or longer repayment term.
This type of refinancing can also be used to shorten your repayment term. Your monthly payment may increase, but you'll pay off your loan faster and spend less in interest over the life of your new loan.
Cash-out refinance
A cash-out refinance lets you tap into the equity in your property. It replaces your existing mortgage with a new, larger loan, giving you access to the difference between the two in real money. The terms of your refinance might differ significantly from your original mortgage loan, including new rates and terms.
Although a cash-out refinance can be a convenient way to access large sums of money to pay for a large expense, home improvements or a remodeling job, it comes with risks. You may pay a higher interest rate than on your existing loan, and if you don't make payments, you risk losing your home to foreclosure.
Also, not all borrowers qualify. You need a certain amount of home equity — usually 20% or more, which can vary by lender and you must meet your lender\'s credit score and debt-to-income (DTI) ratio requirements.
No closing cost refinance
If refinance rates are low, but scraping together the upfront costs is out of the question, a no-closing cost refinance may be the answer. This is especially true if you plan to stay in your home for only a few years.
However, lenders may recoup their closing costs by raising the mortgage rate, wrapping the fees into the financing or rolling the fees into the total principal balance you'll owe. Still, you'll pay no upfront origination fees at closing, which means a shorter break-even point.
FHA refinance
If the Federal Housing Administration (FHA) insured your existing mortgage, you could lower your monthly payments with an FHA streamline refinance. You may even be able to roll your closing costs into the new loan, saving you money upfront, although your lender may charge a higher interest rate to make this happen.
Borrowers often use this type of loan to refinance into a conventional mortgage to eliminate mortgage insurance premiums (PMI).
VA refinance
A VA refinance, or interest rate reduction refinance loan (IRRRL), is for homeowners with an existing mortgage backed by the U.S. Department of Veterans Affairs (VA).
This type of refinance can help borrowers lower their monthly mortgage payments by switching from an adjustable-rate to a fixed-rate loan.
Borrowers who refinance through a VA Interest Rate Reduction Refinance Loan (IRRRL) generally pay a one-time funding fee of 0.5% of the loan amount, in addition to closing costs. The fee can be paid upfront or rolled into the new loan. Some borrowers, including veterans receiving compensation for service-connected disabilities, are exempt from the fee.
USDA Streamlined-Assist Refinance
Homeowners with existing USDA mortgages may qualify for a Streamlined-Assist Refinance through the U.S. Department of Agriculture (USDA), even if they have little or no home equity.
The program generally doesn't require a credit report, home inspection, appraisal or debt-to-income ratio calculation, making it easier for eligible borrowers to refinance. However, exceptions to the appraisal requirement apply to certain USDA Direct loans.
Borrowers must meet USDA income limits, have an acceptable recent mortgage payment history and generally reduce their monthly mortgage payment by at least $50. Refinancing is available through participating USDA-approved lenders.
Cash-In Refinance
A cash-in refinance allows homeowners to make a lump sum payment toward their mortgage when refinancing, reducing the amount they need to borrow. This can help lower interest costs, build home equity and potentially reduce monthly payments.
By reducing the loan balance, borrowers also lower their loan-to-value (LTV) ratio, which may help them qualify for better loan terms or eliminate private mortgage insurance (PMI).
A cash-in refinance may also be an option for homeowners with limited or negative equity, but they must contribute enough cash to meet the lender's refinancing requirements. Before proceeding, consider whether the potential savings justify using a significant portion of your available cash.
Use the tool below to compare some of today's top mortgage refinance offers:
Steps to take to refinance a home
Once you've decided that you want to refinance a home loan, here are the steps you need to take:
- Choose the right type of refinance. Determine whether you want to lower your monthly payment, shorten your loan term or access your home's equity. Your financial goals will help determine which refinancing option makes the most sense.
- Shop around and compare lenders. Get quotes from at least three mortgage lenders and compare interest rates, annual percentage rates (APRs), closing costs and loan terms. Review each lender's Loan Estimate to understand the total cost of borrowing.
- Gather your financial documents. You'll generally need recent pay stubs, W-2 forms or tax returns, bank statements and information about your existing mortgage. Your lender may request additional documentation depending on your financial situation.
- Apply and consider locking your interest rate. Once you've selected a lender, complete the application and decide whether to lock your rate. Rate locks typically last 30 to 60 days, although options vary by lender. Locking protects you against rate increases while your loan is processed, but it may prevent you from benefiting if rates fall.
- Complete underwriting and any required appraisal. Your lender will review your income, credit, debts and property information to determine whether you qualify. Some refinances require a home appraisal, although eligible borrowers may qualify for an appraisal waiver.
- Review your Closing Disclosure. For most refinances, you'll receive a Closing Disclosure at least three business days before closing. Compare it with your Loan Estimate and review the final interest rate, monthly payment and closing costs. Ask your lender to explain any unexpected changes.
- Close on your new mortgage. Once approved, you'll sign the final loan documents. For most refinances of a primary residence with a new lender, you'll have three business days after closing to cancel under the right of rescission, provided you've received the required disclosures. This cancellation period doesn't apply to every refinance.
Does refinancing impact your credit?
Refinancing your mortgage may temporarily lower your credit score, but the impact is usually modest. When you apply for a refinance, lenders typically perform a hard credit inquiry, which can cause a small dip in your score.
The good news is that shopping around for mortgage rates doesn't necessarily mean multiple hits to your credit. Most credit scoring models treat mortgage inquiries made within a 14- to 45-day window as a single inquiry, depending on the model used.
Refinancing also closes your existing mortgage account and opens a new one, which can affect your credit history. However, the impact varies depending on your overall credit profile and generally diminishes over time as you make on-time payments on your new loan.
Should you refinance a home loan?
Refinancing can be a smart financial move if it helps you lower your monthly payments, pay off your mortgage faster or access your home's equity. However, the potential benefits depend on your current loan terms, financial goals and how long you plan to stay in your home.
One of the biggest drawbacks is the closing costs, which can offset your savings. Refinancing may also increase the total interest you pay if you extend your repayment term. For example, replacing a mortgage with 15 years remaining with a new 30-year loan could lower your monthly payment but leave you paying interest for another three decades.
Before refinancing, compare the total cost of your existing mortgage with the new loan, including closing costs and interest. If you plan to sell your home before recovering the upfront expenses, refinancing may not be worth it.
Making the right refinancing decision
Patrick Boyaggi, Co-Founder & CEO of Own Up says, "Refinancing in today's market may not make sense for most homeowners because current market rates are significantly higher than the rates most homeowners secured during the pandemic's low-rate environment."
That doesn't mean refinancing is off the table. For some homeowners, tapping into their home equity to fund renovations, consolidating higher-interest debt or shortening their mortgage term may still make financial sense.
The key is to look beyond the interest rate. Compare your current mortgage with the cost of a new loan, including closing costs, monthly payments and total interest over time.
Ultimately, the right time to refinance isn't necessarily when mortgage rates fall. It's when the numbers work in your favor and the new loan helps you reach your financial goals.
Not sure whether refinancing fits into your long-term financial plans? A financial adviser can help you weigh the potential savings against the costs and determine how a new mortgage could affect your overall financial picture.
Use the tool below to connect with an adviser who can help you evaluate your options:
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