Should You Consider Mortgage Refinance? Here’s How to Think About It

Mortgage payments can take up a good chunk of your income, especially with a new home. And the interest you pay on that mortgage loan is nothing to sneeze at. In 1982, mortgage rates hit an annual average of 16.03%. That means for a 30-year conventional mortgage loan for $250,000, you’d be paying $962,458.72 just in interest over the lifetime of the loan. Crazy, right?

Fortunately, during the past couple of decades, rates haven’t been quite so high. But what if you locked into an interest rate that is significantly higher than where rates are now? Or what if you’ve paid off a good chunk of your mortgage and you want to take some money out? Refinancing might be a good option, depending on your circumstances.

“Keep an eye on interest rates,” says Los Angeles-based loan officer Dan Hunt. “When rates drop, it’s always a good idea to look into refinancing. I have done many refinances over my career that have saved homeowners hundreds of dollars per month and tens of thousands over the life of the loan.”

So is refinancing always the right option? Well … maybe. Although a lower interest rate could save you money over the long run, there are some other factors you should take into consideration before making a move. But don’t worry – we’ve got the important information you need right here.

What is a refinance?

Let’s start with the basics: What exactly does it mean to refinance your mortgage? A refinance is just another way of saying that you’re trading in your current mortgage loan for a new one.

A new loan means new terms — if you got a 30-year conventional, fixed-rate mortgage three years ago and you’re refinancing with a new 30-year conventional, fixed-rate mortgage, then you just hit the reset button on the 30 years it will take to pay off your home. That said, if you want to refinance for a 15-year mortgage instead of a 30-year mortgage, or a custom length of time, many mortgage lenders can and will be flexible with your terms.

However, in the years since you’ve had your home, you’ve likely built up equity in the home, meaning that you would take out less money to refinance your house than you did to buy it. If you qualify for a better interest rate, that could mean a lower monthly payment, depending on the terms of the mortgage you choose. Or you may be able to refinance into a shorter term and pay your home off even sooner.  Refinancing gives you the opportunity to start fresh under new terms that benefit you based on your updated circumstances and the conditions of the current market.

Is a refinance like a purchase?

In many respects, a refinance works like buying a house. You still have to:

Go through the application process

This includes providing financial details and documents.

In some cases, a refinance will not require as much documentation as a purchase, but be prepared to submit pay stubs, tax returns, and any other information you were required to provide for your purchase.

Pay fees and closing costs

This is where things can get tricky. If the fees and closing costs are too high, they can negate the purpose of refinancing. This can particularly be true if you have only been in your home for a short time.

Approximately three years is generally the break-even point for closing costs, unless rates have dropped dramatically since the time you purchased your home. Talk to your licensed loan officer to go over the total costs and the monthly savings to determine if it makes sense.

Get the home appraised

You’ll likely have to pay for the appraisal.

Have the loan underwritten and go through closing again

Your mortgage lender will spend time going through your documents to make sure everything is in order, and you’ll have to sign all of the usual mortgage paperwork when your loan is ready to close.

On the plus side, you will not have to go through any inspections in the process of your refinance.

Benefits of refinancing

So why refinance? The biggest reason why most people refinance is to save money in some capacity. That savings can come in several different forms.

Lower payments

“The main reason people refinance is to save money each month,” explains Hunt.

There are three ways to lower your payments by refinancing:

Lower rates

Interest rates fluctuate over time, and many homeowners decide to refinance because they can get a better (lower) rate than the one they’re currently paying on their mortgage. A lower interest rate generally means a lower monthly payment, but even if lowering your interest rate doesn’t reduce your monthly payment by much due to closing costs attached to the refinance, a lower interest rate could save you money over the life of your mortgage.

Eliminating mortgage insurance

If you are paying mortgage insurance on your loan and have built up at least 20% equity in your home, you can get rid of that additional fee by refinancing. Depending on the amount of your original loan, that could save you hundreds of dollars every month.

And if your home is increasing in value, an appraisal at a higher value could put you over the 20% threshold even if you haven’t made enough payments to take you there. Make sure to consider both factors when determining if you’ve met that 20% threshold.

It is good to note, however, that if you have a conventional loan and you have 22% equity in your home, your lender is required to drop your PMI payment and you are not required to refinance. For an FHA loan, if you put less than 10% down or have been repaying for fewer than 11 years, you may need to refinance to remove your mortgage insurance payment.

Changing term lengths, loan types, and other reasons to refi

When you refinance, even if your interest rate is the same, you may be able to lower your payments by extending your loan term (i.e. resetting the 30-year repayment clock), depending on how much equity you have built in your home. If lowering your monthly bills is the goal, looking into refinancing — even at a similar rate to what you have — might work for you.

And saving money isn’t the only reason to refinance your home. Changing the length of the term is another possible reason for refinancing — for example, if you want to change from a 30-year mortgage to a 15-year mortgage and pay off your mortgage faster.

Changing mortgage types is another reason people typically refinance, such as changing from an adjustable-rate mortgage to a fixed-rate mortgage.

Also, if you’re looking to tap into your home’s equity, some mortgages allow for a certain amount of cash out at refi.

Drawbacks of refinancing

Refinancing sounds great so far, right? Not so fast — there are some possible drawbacks to consider before pulling the trigger on a refi.

Starting over

While you might be saving money on your home refinance, you are also starting over with a new mortgage. That means if you refinance into a 30-year loan, you’ve got another 30 years of payments that you’re responsible for.

“A potential drawback is the fact that you are resetting to another 30-year loan. So you would lose any amortization you have already accumulated,” says Hunt.

Remember, with amortization, you are paying both the loan principal (the amount you borrowed) and loan interest — and the loan interest is prioritized, so your early payments will apply more toward interest than your principal. As you pay off the loan, more and more of your monthly payment applies to your loan principal, strengthening your equity. When you refinance, you’re back to square one with amortization, which will slow down how quickly you continue to gain equity.

Credit score

In order to get approved for a refi, your mortgage lender will have to pull your credit report, which is counted as a hard inquiry against your score. A hard inquiry usually drops your credit score 5 to 10 points. Keep that in mind before applying for a refinance.

The good news is, if you’re committed to a refinance, you have 45 days to shop around for a rate and apply with lenders, and your credit score will only get hit with one hard inquiry. Don’t be shy about applying with multiple lenders — a small difference in rate can save you thousands over the loan term.

Lifetime cost

Here’s the rub to refinancing into a lower interest rate or a lower monthly payment — ultimately, you may end up paying more over the life of the loan than if you had stayed with your original mortgage, even if your monthly payment is reduced.

Upfront cost

There’s no way around it — refinancing a mortgage costs money, in the form of closing costs, taxes, origination fees, and other upfront expenses. Different lenders charge different amounts and some will not charge any at all.  Talk to your licensed loan originator to get a Loan Estimate detailing the estimated upfront costs of your refinance.

When to consider refinancing

Once you’ve made six months’ or more worth of payments on your current mortgage, you can start thinking about refinancing. Some lenders require you to pay on your mortgage for a year or more, but it depends on the specific financial institution.

Some people opt to stay with their current lender to refinance, while others choose a different lender, depending on who’s offering the best rates. If you have a mortgage broker, they can be a resource to recommend which lenders are offering the best terms. If you don’t have a broker, you can always conduct research on rates and terms yourself.

Refinancing can make sense for many reasons, but the strongest is usually to help you meet your financial goals. You might consider refinancing if:

Mortgage rates are significantly lower than when you bought your home

If you purchased your home with an interest rate of 5% and mortgage rates are now at 3.75%, that could mean significant savings over the life of the loan. However, when rates are low, lots of people are interested in refinancing, and the fee to refinance your home loan might increase with demand.

Keep an eye on the Federal Reserve overnight interest rate, as it influences the interest rates banks are offering on mortgages.

Your interest rate also depends on the type of loan you choose, whether or not you have a second mortgage, your credit rating, and other factors.

You want to tap into your home’s equity

If you’ve built up a significant amount of equity in your home and want to tap into that equity, you may want to look at a cash-out refinance. That’s when you replace your current mortgage with a new loan for more than you owe on the home, and take out the difference in cash (minus closing costs and fees).

Cash-out refinancing is an option borrowers often look at for home improvements, purchasing an investment property, paying tuition, paying off high-interest credit cards, or even taking a vacation. A cash-out refinance is an alternative to second mortgage options like a home equity loan or a home equity line of credit, both of which allow a homeowner to tap into their home’s equity, but which typically carry a higher interest rate.

If you choose to do a cash-out refinance on your home, the interest is still tax-deductible — which could be a better alternative than taking out costly credit card debt or a second mortgage.

When should you wait to refinance?

There are a few times where you should hold off on refinancing.

If you haven’t yet made six months of payments on your current mortgage, most lenders won’t let you refinance. There’s also the possibility that the costs associated with refinancing could negate the purpose of refinancing if you haven’t built any more equity in your home.

If interest rates have not dropped substantially — or have gone up — you may want to hold off as well, especially if your goal in refinancing is to save money.

Another time it’s best to wait is if you have a low credit score.

“It would be a good idea to hold off on a refinance if you need to improve your credit. Most interest rates are directly tied to your credit score. The higher the score, the lower the rate.  So sometimes I have to work with people and put them on a plan to improve their credit so when we start the process they are in a position to get the best rate possible,” explains Hunt.

So is now a good time to refinance? Maybe. The answer is specific to every individual, regardless of the interest rate environment. Check with your mortgage professional to get advice before making any sudden moves.

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