A mortgage is a long-term commitment, but you can adjust the details along the way to match your financial situation and goals as they change. Refinancing your mortgage can be a great way to restructure your overall finances.
When you refinance a mortgage, you repay your current loan with a new one that has better terms. Some homeowners refinance to secure a lower interest rate or to lower their monthly mortgage payment. Others do so to repay their home loan more quickly. Homeowners also refinance to consolidate high-interest debts or to pay for home renovations and repairs.
But refinancing comes with tradeoffs, so it’s important to decide if it’s right for you. Here’s what you need to know about refinancing your mortgage, including when it makes sense to refinance and key steps to take:
- What Is Mortgage Refinancing?
- Why Refinance My Mortgage?
- Is It Worth Refinancing My Mortgage?
- When Should I Refinance My Home?
- When Should I Not Refinance My Home?
- How Do I Refinance My Mortgage?
- Mortgage Refinance FAQ
- The Bottom Line on Refinancing
What Is Mortgage Refinancing?
When you refinance your home mortgage, you pay off your current loan with a new mortgage that has more favorable terms. Refinancing can help you achieve your financial goals by reducing the total cost of your loan, shortening your loan term, or providing cash for repairs and renovations that increase the value of your home.
But there are risks, depending on the terms of your new loan — such as a higher monthly payment or greater overall cost. It’s important to make sure the new mortgage suits your financial needs and goals.
“The advantage should be to put the borrower in a better financial position than they are now,” says Brad Walters, a strategic financing advisor at Real Estate Bees, and president of Castle Hills Mortgage in Lewisville, Texas.
Why Refinance My Mortgage?
There are plenty of reasons to refinance your mortgage. Depending on market conditions and your financial situation, refinancing can make your monthly payment more affordable, allow you to repay your mortgage more quickly, or convert some of your home’s equity into cash.
Save money with a lower interest rate
Interest rates change with the economy. For example, the Federal Reserve has kept interest rates low to counter the economic impact of the COVID-19 pandemic, which means current rates could be lower than when you took out your loan. If rates are lower now, refinancing can reduce the total amount of interest you pay by thousands of dollars.
Your new loan likely will have a longer term than what you had left on your previous mortgage, so it’ll take you longer to pay the loan. To avoid this, you can ask your lender for a custom term — for example, 22 years instead of the typical 30.
Reduce your monthly payment
If you’re spending too much on housing for your budget to handle, refinancing to a longer term can reduce your monthly mortgage payment and make it more affordable. However, keep in mind that you could end up paying more interest over the life of the loan.
Pay off your mortgage more quickly
Perhaps you make more money now than when you took out your home loan, and you’re interested in paying it back more quickly. You can refinance to a shorter term — for example, from 30 years to 15. The benefit is avoiding 15 years of payments and lots of interest charges. But doing this will increase your monthly mortgage payment, so be sure you can afford it.
Another good reason to refinance is to stop paying for private mortgage insurance. If you have a conventional loan and made a down payment of less than 20% of the home’s value, then you’re likely paying for PMI, which protects the lender if you’re unable to make your mortgage payments. But once you reach 20% equity in your home, you can stop paying for PMI — reducing your monthly payment.
Lock in your interest rate
A fixed-rate mortgage has the same interest rate for the entire term of the loan. But with an adjustable-rate mortgage, the interest rate can change, which means your monthly payment also may fluctuate.
When you sign up for an ARM, your interest rate and payment amount will remain the same for a specified period that can range from one month to five years. After that, your rate and payment are subject to change every month, quarter, year, three years, or five years, depending on your mortgage.
The upside of an ARM is that lenders typically offer a lower interest rate to start. If rates remain low, then your ARM may be less expensive than a fixed-rate mortgage. But you always risk rates going up, which would increase your monthly payment.
If you prefer predictability, you can refinance to a fixed-rate mortgage.
Consolidate or pay your debts
If you have high-interest debts, like credit cards, you can tap into your home’s equity to pay them off with a cash-out refinance. Equity is the difference between the current market value of your home and the amount that you owe.
Say your home’s fair market value is $300,000 and you owe $100,000 in principal on your mortgage. You have $200,000 in equity in your home. If you refinance to a new $120,000 loan, then $100,000 of that amount would be used to retire your previous mortgage, and you’d be left with $20,000 to pay those high-interest debts.
Your new mortgage would reflect the updated principal balance of $120,000. You will have effectively added the high-interest debt to your home loan but will pay it off over time at a much lower interest rate. Your monthly mortgage payment likely would be higher than what you paid before, but it should still be less than the combined cost of your previous mortgage and your high-interest debts.
Pay for home renovations or repairs
Similarly, you can use a cash-out refinance to cover renovations or repairs. Since equity is tied to the value of the home — you gain equity as your home’s value increases and lose it if your home’s value declines — it may make sense to use your equity to invest in home improvements.
Renovations can be expensive, but you’ll pay less interest using a cash-out refinance than a credit card or a personal loan. Cash-out refinances tend to have lower interest rates than those alternatives. So, even though the refinance is still a loan, you can justify the amount you’re adding to your total debt knowing that you’re increasing your equity by upgrading your home.
Invest in your retirement
Another way you can use your equity in a cash-out refinance is to increase your contributions to retirement accounts. The sooner you invest in your retirement, the more you’ll be able to take advantage of the compounding interest. In other words, you’re getting more money in those accounts sooner to maximize the number of years that money can earn interest.
Just remember, the refinance is a loan that increases what you owe, so you’ll still need to repay the amount you’re taking out to invest in your retirement. Consider consulting with a trusted financial advisor to evaluate if the investment is worth it.
Is It Worth Refinancing My Mortgage?
Whether it’s a good idea to refinance will depend on the terms of the loan and your goals.
If you’re looking to save money in the short term, then you should refinance if interest rates are low enough for you to reduce your monthly mortgage payment. Remember that while your monthly payment will be lower, you’ll extend the term of your loan, which means you’ll make more payments and pay more interest over time.
If your financial situation has improved, then you may want to refinance to shorten the term of your loan and reduce the overall interest you’ll pay. Just make sure you’re prepared to pay more each month.
Regardless of why you’re refinancing, you should carefully review the terms and identify the total cost of the loan, which could eat into your potential savings. This will help you determine whether it’s worth the cost to refinance.
Use a mortgage refinance calculator
You can use a free mortgage refinance calculator to explore different loan types and figure out your new monthly payment, interest rate, and savings.
Find your break-even point
Once you’ve worked out the details of refinancing, it’s important to compare the total costs to your current loan to figure out when your refinance will start saving you money.
“It is not all about interest rate, although this is a big component,” Walters says. “It is also about closing costs. If the closing costs are greater than the savings, there is no benefit.”
Be sure to factor in any additional refinancing costs to calculate your break-even point, which is when the amount you’ve saved can justify the cost of your new loan. This is the time when you’ll recoup the costs of refinancing and begin saving money. It’s important to know because your break-even point may take years to reach.
When Should I Refinance My Home?
There are certain times when it will make more sense to consider refinancing, but be sure to evaluate both your financial situation and market conditions.
When your credit improves
The terms of your mortgage are affected by your credit history. If you’ve paid off significant debts since you took out your mortgage, then your credit score likely has changed for the better. That means it might be a good time to refinance with your new and improved credit score to get a lower interest rate.
When interest rates go down
If interest rates are better than when you took out your mortgage, you can refinance to take advantage of the lower rates. Even though you were paying a higher interest rate before rates fell, you can still save money by refinancing to a shorter term at the same time.
When Should I Not Refinance My Mortgage?
Here are some instances where it may not be a good idea to refinance your mortgage:
- Your credit score has dropped. Your credit affects the terms of the loan and the interest rate you’re offered. So, if your credit score is lower than when you got your original mortgage, then it may be difficult to find a better deal than the loan you have now.
- You’re not planning to stay in place. Consider holding off on refinancing if you intend to move in the next few years. That’s because you wouldn’t be paying into the mortgage long enough to reach your break-even point and recoup the cost of refinancing.
- The value of your home has decreased. It likely will be more difficult to refinance with favorable terms if your home’s value has declined — especially if you have negative equity, which is when you owe more than what your home is worth.
- Your mortgage has a prepayment penalty. Some mortgages include a prepayment penalty, which means you’ll have to pay an extra fee to refinance.
“I’ll recommend not refinancing a mortgage when it does not meet the needs of the borrower or put them in a better financial position,” Walters says.
How Do I Refinance My Mortgage?
So, how does refinancing work? The refinancing process is similar to getting a mortgage. Here’s what happens when you refinance a mortgage, according to Walters:
- You submit an application. You apply to refinance with a lender and pay any application fees.
- The lender checks your credit. Your mortgage lender makes a hard inquiry on your credit report.
- You provide documentation. These are many of the same documents you needed to get your existing mortgage, including proof of income, assets, and liabilities.
- An appraisal might be ordered. Your lender will likely want to verify the current value of your home, which may have changed since you first took out your mortgage.
- The loan goes to underwriting. This is the part where your lender verifies your income, debts, and assets, and may request additional documentation.
- Your new mortgage is closed. After you’re approved, the new loan will replace your previous loan. If you’re cashing out, then you’ll receive that money several days after closing.
Mortgage Refinance FAQ
Here are the answers to some frequently asked questions about refinancing your mortgage.
Homeowners can save hundreds of thousands of dollars by refinancing their mortgage, according to Walters. The exact amount that you’ll save varies based on factors like current interest rates and your loan term.
Refinancing can temporarily ding your credit because lenders make what’s called a hard inquiry on your credit report. However, if you continue making your payments on time, your credit score will generally bounce back.
If you’re applying to several lenders, then you should submit all your loan applications at the same time to minimize the effect on your credit score. Typically, different loan inquiries that occur within the same 14-day to 45-day period count as one hard inquiry. Otherwise, your credit score could get banged up thanks to multiple hard inquiries.
You can avoid paying closing costs by seeking a “no-closing-cost refinance.” While you won’t pay the additional fees upfront, that doesn’t mean you’re off the hook. Your lender likely will wrap those fees into your interest rate or total loan amount, which means you could wind up paying more per month or overall.
The Bottom Line on Refinancing
Tapping into the value of your home via refinancing is one of the great advantages of homeownership — especially when home values are increasing. Refinancing can help you snag a lower interest rate and monthly payment, pay off your home sooner, or invest in renovations or your retirement. When interest rates drop or your credit improves, it’s a good opportunity to consider refinancing your mortgage. Just be sure to weigh the potential pros and cons of a new loan before you pull the trigger.