How Does Refinancing a Mortgage Work? A Homeowner Planning Guide

Top reasons homeowners refinance

Homeowners choose to refinance their mortgage for a variety of reasons, each offering its own set of benefits. Here are some of the top reasons:

1. Lower interest rates: One of the most common reasons for refinancing is to secure a lower interest rate, which can significantly reduce monthly mortgage payments and total interest costs over the life of the loan.

2. Shorten loan term: Refinancing can allow homeowners to switch from a 30-year to a 15-year mortgage, for example. This can lead to paying off the loan faster and saving on interest, despite a potential increase in monthly payments.

3. Convert between adjustable-rate and fixed-rate mortgage: Homeowners might refinance to switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage for more predictable payments, or vice versa for lower initial rates.

4. Cash-out equity: As seen in the cash-out refinance example, homeowners can tap into their home equity to cover large expenses, such as home renovations or debt consolidation.

5. Remove private mortgage insurance (PMI): If a home’s value has increased, refinancing can help homeowners reach 20% equity, allowing them to eliminate PMI and lower their monthly expenses.

6. Debt consolidation: By consolidating high-interest debts into a mortgage with a lower interest rate, homeowners can manage their finances more effectively.

Drawbacks of refinancing your mortgage

While refinancing can offer significant benefits, it’s important to be aware of its potential drawbacks. Here are some key considerations:

1. Closing costs: Refinancing a mortgage involves closing costs, which can range from 2% to 6% of the loan amount. These costs can add up, potentially offsetting the savings gained from lower interest rates.

2. Longer loan term: If you refinance into a new 30-year loan, for instance, you could end up paying more in interest over the life of the loan, even if your monthly payments are lower.

3. Risk of foreclosure: By refinancing, you’re essentially taking out a new mortgage. If you fail to make payments, you risk foreclosure, just as with your original mortgage.

4. Lost benefits: Some original mortgages might have special features like federal loan forgiveness that could be forfeited upon refinancing.

5. Impact on credit score: Refinancing can temporarily impact your credit score due to the lender’s credit inquiry and the closing of the old mortgage account.

6. Potential for higher payments: If you opt for a cash-out refinance, your overall loan balance increases, which could lead to higher monthly payments.

7. Borrower’s remorse: If interest rates drop substantially after you close on your refinance, you might have regrets about the timing and costs.

8. Interest rate risk: For those switching to an adjustable-rate mortgage, there’s the risk of interest rates increasing in the future, which could raise monthly payments.

How much does it cost to refinance a mortgage?

Refinancing a mortgage typically costs between 2% to 6% of the loan amount. These costs include application fees, appraisal fees, title searches, and closing costs. For example, refinancing a $200,000 loan might cost between $4,000 to $12,000.

But Hammond reiterates that it’s important to consider the overall price of refinancing. “Don’t get caught up in interest rates.”

If you’re planning to move within the next year or two, the costs of refinancing may actually cause you to lose money. Similarly, if your loan balance is relatively low, you may be better off sticking with your current mortgage.

“If I have a $100,000 loan balance and I can reduce my rate by 1%, that sounds like a lot, but in terms of real dollars, it won’t reduce the payment by much,” says Hammond, who warns that a portion of the costs associated with refinancing are flat-rate and independent of the loan size.

“If an appraisal costs $425 and a closing attorney costs $495, I’m paying those amounts regardless of whether I’m refinancing $100,000 or $500,000. The dollar for dollar [on these costs] is the exact same, but saving 1% interest on $500,000 is far more substantial.”

Hammond encourages homeowners to talk through the process with a trusted lender and put a plan together that finds the most efficient use of their time and money.

The same rationale applies if you’re looking to shorten your loan term, remove mortgage insurance, or take out cash from the equity in your property.

“The refinance transaction where you only drop your interest rate by a quarter of a point but you also eliminate your monthly mortgage insurance? That’s a transaction you do all day long,” says Hammond. “That’s going to be a huge dollar figure in terms of savings.”

If you’re looking to shorten your loan — say, refinancing from a 30-year mortgage to a 15-year mortgage — your monthly payment may increase while your interest rate goes down, allowing you to pay down the loan principal more rapidly, if you’ll be in the house long enough for the numbers to make sense.

Is refinancing your mortgage right for you?

Deciding to refinance your mortgage is a significant financial decision. “It’s not a good idea or a bad idea,” says Hammond. “It’s an idea to be discussed. You hash it out and let the numbers tell you what makes the most sense.”

To determine if it’s the right choice for your situation, ask yourself these questions:

1. Will refinancing lower my rate or payments enough to justify the costs? Consider if the savings from refinancing outweigh the closing costs and fees involved.

2. How long do I plan to stay in my home? If you plan to move soon, you may not stay long enough to recoup the costs of refinancing.

3. What are my financial goals? Are you looking to reduce monthly payments, pay off your mortgage faster, or use your home equity for large expenses?

4. How will refinancing impact my overall financial plan? Think about how changing your mortgage terms fits into your broader financial strategy.

5. Am I prepared for the potential impact on my credit score? While usually temporary, refinancing can affect your credit, so consider the timing if you have other major credit applications planned.

Refinancing can offer significant financial benefits, but it’s not a one-size-fits-all solution. Each homeowner’s financial situation is unique. Consider consulting with a financial advisor to ensure that your choice to refinance aligns with your long-term financial plans. This professional guidance can help you make an informed decision that best suits your individual needs and goals.

Learn more: See our list of upgrades that can add value to your home.

Writer Summer Rylander contributed to this story.

Header Image Source: (Jessica Furtney/ Unsplash)