This article will help you understand the ins and outs of a mortgage refinance. It will explain what refinancing means, explore the main types of refinancing options, and cover when it’s a good time to refinance. Finally, it will show how you can calculate whether or not refinancing makes financial sense for you.
The post-pandemic housing market is like none we’ve seen before. Mortgage rates remained at historic lows at the start of 2022, but have already started to rise midway through the year. Learn how to find the best rate for you from our walkthrough of understanding mortgage interest rates. Home values, meanwhile, have soared as buyers have driven demand for a limited supply of homes for sale. Nationwide home prices rose at a rate of 18.1% from August 2020 to August 2021. So a house worth $400,000 in August 2020 would on average have been worth $472,000 just a year later!
All of this is leading many homeowners to ask the simple, yet complex question: “Should I refinance?”
Unfortunately, there’s no one-size-fits-all answer to that question. The good news? By following some simple rules of thumb and doing a little math, you can decide for yourself if and when the time is right to refinance your current home loan.
What it means to refinance
Think back to when you bought and financed your current home. You contacted a mortgage lender, completed a loan application, got approved, paid closing costs, and finally received money from the lender that you used to finance your purchase. You’ve been re-paying that loan ever since, through monthly mortgage payments of principal and interest according to the terms and amortization schedule set by the lender.
When you refinance an existing mortgage loan, you go through this process all over again — with one exception. Instead of using the money to buy a home, you use the money to pay off your existing mortgage. You then have a new mortgage with a new term and interest rate.
Refinancing can help you save money by taking advantage of interest rates that are lower than when you originally bought your home. Many lenders will allow you to leverage the equity you’ve built in your home — leverage you can use to get money out to help pay for large expenses. Terms vary by lender, which is why it’s always a good idea to contact several before making a decision. Read our guide to choosing a refinance lender to help ensure you find the best rates. We’ll look closely at some of these reasons you may want to consider refinancing later in this article.
The primary types of refinancing
There are two main types of refinancing available to you: rate-and-term refinance and cash-out refinance. Which one you choose will be determined by your financial goals.
Rate and term refinancing
With rate-and-term refinancing, you enter into a new mortgage with a lower interest rate and possibly a different term (e.g., 15 years or 30 years). The principal balance — the money you owe the lender, minus interest — remains the same.
Rate-and-term refinancing makes sense if current interest rates are significantly lower than what you’re paying on your existing mortgage. This can happen either because rates have dropped, or because your credit score and other personal financial factors have improved to the point where you’re now eligible for better rates.
Paying less interest on the new loan enables you to do one of two things:
- Have a shorter loan term to save money over the life of the loan
You may pay a little more each month. But the lower interest rate, possibly combined with a shorter loan term, will help you pay off your mortgage balance quicker and ultimately save money in the long run.
- Have a longer loan term but save money each month with a lower monthly payment
It will take you longer to pay off the loan completely. But by “stretching” the payments over a longer-term while taking advantage of the lower interest rate, you’ll have a lower monthly payment. This frees up monthly cash flow for your other financial goals.
Rate-and-term refinancing is also an option if you’re looking to convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage. If you prefer a stable rate to one that might change, this is an option worthy of consideration.
Here’s a simplified example of how to calculate your savings with a rate-and-term refinance.
Let’s say that ten years ago, you bought a home for $250,000. You made a 20% down payment, so you financed $200,000 with a 30-year fixed-rate mortgage and a 5% interest rate. Using a Mortgage Calculator featuring an amortization schedule, the total payoff value of the loan calculates to $386,640. Your monthly payments (principal and interest only) have thus been $1,074.
After ten years of regular, monthly payments, the principal balance now stands at $161,491. To pay off the loan, you’ll need to make monthly payments of $1,074 for 20 more years, equaling $257,760.
Thanks to your excellent credit history, you qualify for a 15-year, fixed-rate mortgage with a 3% interest rate. If you refinance to this new loan, you’ll finance the $161,491 principal balance.
Your new monthly payment will be $1,115 — a little more than what it was before. However, because you’ll pay off the loan in only 15 years instead of 20 (that’s 60 fewer payments!), the total cost to pay off the new loan completely will be only $200,700.
You’ll also need to pay closing costs on the refinance mortgage, which we’ll estimate at $5,000 for our example.
Your savings? $257,760 – $200,700 – $5,000 = $52,060
This decision to refinance from a 30-year fixed to a 15-year, fixed-rate mortgage will save you a total of $52,060 over the life of the loan!
Finally, you should calculate the break-even period. This compares the cost of the refinance (your closing costs) to your monthly savings from the lower interest rate. Compare the amortization schedule of your current mortgage to the amortization schedule of the refinance mortgage.
In this example, you’ll pay $12,558 in interest for the current loan over the next 18 months. In that same period, you’ll pay $7,327 in interest for the new loan.
$12,558 – $7,327 = $5,231. So in 18 months, you’ll save enough in interest payments to make up for the closing costs. That would be your break-even period.
With cash-out refinancing, you can take advantage of the equity in your home to access money you can use today for your personal financial goals. You replace your current loan with a higher value loan and take out a portion of your home’s equity as cash.
The money made available in a cash-out refinance is typically used for the following purposes:
- Cash for debt consolidation
Suppose you have high-interest-rate debt across multiple accounts (such as credit card debt, unsecured personal loans, etc). You can use a cash-out refinance to consolidate these other loans under one monthly payment, typically at lower interest rates and better terms.
- Cash to complete home renovations
Cash-out refinancing can provide the money you need to remodel a kitchen, renovate indoor and outdoor living spaces, or make major home repairs. Investing in home improvements lets you enjoy upgrades while increasing the value of your home. If you need to borrow money to complete renovations or repairs, a cash-out refinance may provide it at a lower interest rate than a credit card, personal loan, or higher interest home equity loans.
- Cash to invest in the future
If you aren’t maxing out your retirement savings, you can consider doing a cash-out refinance to access additional investment funds. Make sure you’re financially responsible in such investment decisions, and get the help and support of trusted financial professionals.
Here’s another quick example, this time showing how cash-out refinancing works to your benefit:
You bought a home for $250,000 and financed $200,000 with a 30-year fixed-rate mortgage at 5% interest. Now, ten years into the mortgage, you owe $161,491 in principal. A home appraisal determines that your home is now worth $300,000.
Your lender offers you a cash-out refinance for 30-years at 3.5% and is willing to loan you up to 75% of your home’s current value — which is $225,000 in this example. At the closing of this cash-out refi, you’ll pay off the original $161,491 balance and can take the remainder of the financed loan as cash into your bank account ($225,000 – $161,491 = $63,510).
So let’s say you decide to only take $50,000 of that available cash at closing to pay for some home renovations. Your new mortgage will be that amount, plus the amount to pay off the loan: $50,000 + 161,491 = $211,491. You’ll have a new, 30-year mortgage with a monthly payment reflecting the new interest rate.
Cash-out refinance loans may come with higher interest rates than rate-and-term refinance loans. The lender may also offer to charge you points, or money you pay upfront to earn a lower interest rate. Because cash-out refinance loans are more complex than rate-a nd-term loans, they usually have higher underwriting standards. If you’re interested in learning more, checkout our Cash Out Refinance options.
A note to US armed services active members, veterans, and surviving spouses: The Veterans Administration offers a VA cash-out refinance loan program to help you leverage the equity in your home to get cash out. It features loans of up to 100% of the value of your home. This could be a good option if you’re looking for cash to pay off high interest debts, make improvements to your home, or invest for your financial future. Further, if you’re 62 or over, you could consider a reverse mortgage as an option to pull tax-free equity from your home.
The cost to refinance a mortgage
As explained in our examples, your lender will require you to pay closing costs when you refinance. These consist of a variety of fees bundled together. Typical closing costs range from 3% to 6% of the value of the mortgage. Remember to factor closing costs into your loan comparison calculations to be sure that refinancing will help you meet your financial goals.
When refinancing is a bad idea
Can refinancing be a bad idea? Again, there’s no simple answer but for some homeowners it does not make smart financial sense. Refinancing “successfully” depends on how well you can match your financial goals with the outcome of your new mortgage loan. Here are a few situations where a refinance is not in your best interests.
- You plan to move before the end of your break-even period. As explained above, the break-even period is the time it takes for the interest savings of the new loan to exceed the costs of the new loan. Moving before the break-even date means you’ll lose money on the refinance.
- Your credit score has dropped. Remember, lenders underwrite refinance mortgages in much the same way they underwrite conventional mortgages. They’ll want to look at your credit score, along with factors such as your debt-to-income ratio. If these have become unfavorable in the lender’s eyes, you may not qualify for the rate you want, or you may have a hard time refinancing at all.
- You don’t have much equity in your home. Equity is the amount of money you have in your home that isn’t tied up by your mortgage. You can calculate this by subtracting the balance of your current mortgage loan from the appraised market value of your home. Your lender may require a certain amount of equity in your home before giving you an option to refinance.
- Refinancing will cost more in the long run. While refinancing for a lower monthly payment is an option we discussed above, you’ll want to avoid a situation in which your new mortgage costs you considerably more in the long run than the original mortgage.
- You can’t afford a higher monthly payment. In our example above, we shortened our loan term, paying less overall while raising our monthly payment. While paying less on the total cost of your mortgage seems like an attractive proposition, make sure your budget can accommodate a potentially higher monthly payment. Another option to consider is accelerating payments to pay off your loan faster. Checkout our early mortgage payoff calculator to determine the benefits of make some extra payments to your current mortgage balance.
- You’re risking your home’s equity. A cash-out refinance can be helpful for the financial reasons explained above. Just remember that this refinance involves creating extra debt using your home’s equity as collateral. If you plan to make high-risk financial decisions in a cash-out refinance, then a refinance may be a bad idea.
Should you refinance? With a clear understanding of your financial goals, a little math, and an understanding of how the process works, you can answer the question in a way that works best for you.