When Should You Refinance a Home?

It makes sense to refinance a home when it will save you money or make paying your monthly bills easier.

Some experts say you should only refinance when you can lower your interest rate, shorten your loan term or both. That advice isn’t always correct. Some homeowners may need short-term relief from a lower monthly payment, even if it means starting over with a new 30-year loan. Refinancing also can help you access the equity in your home or get rid of an FHA loan and its monthly mortgage insurance premiums.

How Refinancing a Mortgage Works

When you refinance, you get a new mortgage to pay off your existing mortgage. Refinancing works just like getting a mortgage to buy a house. You’ll be free from the stress of home buying and moving, though, and there’s less pressure to close by a certain date. Further, if you regret your decision, you have until midnight of the third business day after your loan closes to cancel the transaction.

From April 2019 through August 2020, the average time to refinance a conventional mortgage ranged from 38 to 48 days, according to Ellie Mae’s Origination Insight Report. When interest rates drop and many homeowners want to refinance, lenders get busy and refinancing can take longer. Refinancing an FHA or VA loan can also take up to a week longer than a conventional refi.

When Refinancing Your Home Loan Makes Sense

Refinancing can lower your monthly mortgage payment by reducing your interest rate or increasing your loan term. Refinancing also can lower your long-run interest costs through a lower mortgage rate, shorter loan term or both. It also can help you get rid of mortgage insurance.

Closing costs such as the origination fee, appraisal fee, title insurance fee and credit report fee are always an important factor in deciding whether to refinance. These costs typically amount to 2% to 6% of the amount you’re borrowing.

You’ll need to know the loan’s closing costs to calculate the break-even point where your savings from a lower interest rate exceed your closing costs. You can calculate this point by dividing your closing costs by the monthly savings from your new payment.

Here are a few examples of how a break-even period works.

A break-even period of 25 months is fine, and 50 might be, too, but 75 months is too long. There’s a good chance you will refinance again or sell your home in the next 6.25 years. Between 1994 and the first quarter of 2020, the median number of years a borrower has kept a mortgage before refinancing is 3.6 years, according to data from Freddie Mac.

If you think your new loan will be your last, make sure to account for any additional years of interest you will be paying. For example, if you have 27 years left and you’re starting over with a 30-year refi, that’s three extra years of interest, and your break-even period is longer.

Now, let’s talk about the most common reasons to refinance.

Grabbing a Lower Interest Rate

When market interest rates drop, refinancing to get a lower interest rate can lower your monthly payment, lower your total interest payments or both.

Another thing that can lower your monthly payment is paying interest on a smaller principal amount, possibly over more years.

In the first quarter of 2020, which mostly includes pre-pandemic refinance activity, 55% of borrowers who refinanced maintained their current principal balance or increased their balance by less than 5% (by financing their closing costs), according to Freddie Mac data. This is the most common choice: a rate-and-term refinance.

A higher credit score will help you get a better interest rate on your mortgage. To get the best rates, you’ll need a credit score of 760 or higher. Almost 3 in 4 homeowners who refinanced in April 2020 had a credit score of 750 or higher, according to mortgage processor Ellie Mae. The average FICO score was 763.

Bringing cash to closing might also get you a slightly lower interest rate or allow you to avoid private mortgage insurance (PMI). Three percent of borrowers did this during the first quarter of 2020.

Refinancing to Access Your Home’s Equity

In the first quarter of 2020, 42% of all refis involved an increased principal balance by at least 5%, indicating the owners took cash out, financed closing costs or both. While cash-out refi rates can be a bit higher than rate-and-term refinance rates, there still may be no cheaper way to borrow money.

You can access your home equity through a cash-out refinance if you will have at least 20% equity remaining after the transaction. Here’s an example.

If your only goal is to get cash and not to lower your interest rate or change your loan term, a home equity loan or line of credit may be less expensive than the closing costs on a cash-out refi.

Refinancing to Get a Shorter Loan Term

If you refinance from a 30-year to a 15-year mortgage, your monthly payment will often increase. But not only is the interest rate on 15-year mortgages lower; shaving years off your mortgage will mean paying less interest over time. The interest savings from a shorter loan term can be especially beneficial if you’re not taking the mortgage interest deduction on your tax return.

That said, with mortgage interest rates so low, some people prefer to spend more years paying off their home so they have more cash to invest at a higher rate and more years for their investment earnings to compound.

In 2019, 78% of borrowers refinanced from a 30-year fixed-rate mortgage into the same loan type, according to Freddie Mac. Another 14% went from a 30-year to a 15-year fixed. And 7% went from a 30-year to a 20-year fixed.

Refinancing to Get Rid of an FHA Loan

FHA loans have mortgage insurance premiums (MIPs) that cost borrowers $800 to $1,050 per year for every $100,000 borrowed. Unless you put down more than 10%, you must pay these premiums for the life of the loan—which means the only way to get rid of them is to get a new loan that isn’t backed by the FHA.

Refinancing to Get Rid of PMI

Eliminating private mortgage insurance on a conventional loan is not, by itself, a reason to refinance. Unlike FHA MIPs, you don’t have to get rid of your loan to get rid of PMI. You can request cancellation once you have enough equity—typically 20%.

Refinancing to Switch from an Adjustable-Rate to a Fixed-Rate Loan, or Vice Versa

Some borrowers refinance because they have an adjustable-rate mortgage and they want to lock in a fixed rate. But there are also situations when it makes sense to go from a fixed-rate to an adjustable-rate mortgage or from one ARM to another: Namely, if you plan to sell in a few years and you’re comfortable with the risk of taking on a higher rate should you end up staying in your current home longer than planned.

30-Year Vs. 15-Year Refinance Mortgage

Most of your monthly payments go toward interest at the beginning of a 30-year loan. You’ll have little home equity for many years unless you’re able to build it faster through home-price appreciation or extra principal payments. Refinancing into a 15-year mortgage helps you build equity faster, but it may increase your monthly payment, as the table below shows.

Is it Worth Refinancing Into a 15-Year Mortgage?

For some people, getting a lower monthly payment is the most important reason for refinancing. It may not be an ideal long-term plan to recommit to 30 years of payments, but it may be essential to keeping your home and paying your bills in the short term. If things improve later, you can pay down your principal faster to save money, or even refinance again.

Calculate Your Mortgage Refinancing Savings

To calculate your monthly savings from refinancing, use a mortgage calculator to enter these numbers and get your new monthly payment:

• Amount to refinance (your current principal balance, or your current principal balance plus the amount you’re cashing out, or your current principal balance minus the amount you’re cashing in)
• New interest rate
• New loan term

Compare your new monthly payment to your old monthly payment. The table below shows how grabbing a lower interest rate could save you $204 per month, or $2,448 per year.

Don’t just look at the monthly payment, though. How much will each loan cost you in total interest assuming you pay off the mortgage and don’t sell your home or refinance again?

To get this information, select the calculator’s option to view the amortization table. At the bottom, you’ll see the total interest for the new mortgage. Write that number down.

Then, do a new calculation with the mortgage calculator. Enter your:

• Original principal amount
• Current interest rate
• Current loan term

Then, view the amortization table for that calculation and see what your current total interest over the life of the loan will be. How much will you save in the long run by refinancing?

Keep in mind that you’ve already paid several years’ worth of interest on your current (original) loan, so your savings is not $162,000 minus $113,000. It’s $162,000 minus $113,000 plus the interest you’ve already paid.

Find the Best Refinance Rates

To find the best refinance rates, you’ll have to do some work, but it won’t take much time. Look at banks, credit unions and online comparison sites. You also can work with a mortgage broker if you want someone to do the legwork for you and potentially get you access to lenders you wouldn’t find on your own—lenders that might offer you better terms.

Submit three to five applications to secure formal loan estimates. The government requires the loan estimate to show your estimated interest rate, monthly payment and closing costs on a standard form that makes it easy to compare information across lenders.

On page 3 of the loan estimate, you’ll see the annual percentage rate, and on page 1, you’ll see the interest rate. When you’re buying a car, it usually makes sense to pick the loan with the lowest APR, because APR includes a loan’s fees.

With mortgages, it’s different. The APR assumes that you will keep the loan for its full term. As we’ve already seen, that doesn’t usually happen with home loans. You might be better off with a loan that has a higher APR and a higher monthly payment but no fees.

Instead of putting cash toward closing costs, you could keep that money in your emergency fund or use it to pay down debt with a higher interest rate than your mortgage.

Another problem is that if you’re comparing the APRs on a 30-year and a 15-year loan, the 15-year loan might have the higher APR despite being much less expensive in the long run.

8 Steps to Refinancing a Mortgage

1. Do the math to see if refinancing makes sense.
2. Decide what type of mortgage to refinance into.
3. Get loan estimates from three to five lenders.
4. Apply with the lender that offers the best price.
5. Gather and submit the required financial documents.
6. Lock your interest rate (could happen after step 4).
7. Three days before closing, make sure your closing cost statement is in line with your loan estimate.
8. Sign the closing paperwork.

Mortgage Refinancing Benefits

Depending on what type of mortgage you’re paying off and what type you’re refinancing into, the benefits of refinancing your mortgage might include the following:

• Lower your monthly payment
• Pay less interest over time
• Cash out some equity
• Stop paying mortgage insurance premiums

Mortgage Refinancing Drawbacks

• Increase your monthly payment
• Pay more interest over time
• Pay closing costs
• Spend time shopping for a new mortgage and submitting required paperwork