Should I Refinance My Mortgage?

Mortgage rates dropped below 4% within the last few months. Does that mean it’s time for you to refinance and lock in a lower rate? 

Homeowners refinance for all sorts of reasons: to lower their monthly payments, to change the amount of time they have to repay their loan, to get some of their equity back in the form of cash to apply toward other financial needs, and, yes, to lower their interest rate, which may save you tens of thousands of dollars in interest over the life of the loan. But as with any big financial decision, it helps to consider your unique situation and understand how refinancing works before you take action.

How does a refinance work?

In a nutshell, this is what happens when you refinance a loan: you take out a new loan, use it to pay off the remaining balance of your original loan, and then begin making payments toward the new loan. The terms on the new loan are more favorable to you, depending on what your needs are. You can look for loans with:

• Lower interest rates, which can help you save on total interest paid over the life of the loan.
• A lower monthly payment, which can make what you owe month-to-month a bit more manageable, but you may end up stretching the loan term to a longer time period and therefore owe more in interest overall.
• A shorter term, which helps you save on interest but often means a higher monthly payment.
• A fixed interest rate. It’s common for homeowners with an adjustable-rate mortgage to refinancing to a fixed-rate mortgage before their original interest rate adjusts.
• The ability to tap into your home equity. You can refinance to a loan that’s larger than the amount you currently owe and get the difference back in cash. Some homeowners do this to finance renovations or other large expenses.

There are trade-offs to all of these options, which is why it can be so helpful to work with a financial planner as you decide. They can work with you to compare these options to your current mortgage, and may even come up with some alternative ideas.

What does refinancing cost?

Remember all those closing fees you paid when you first bought your home? When you refinance, you pay closing costs all over again — that’s about 2-4% of the total amount you’re going to borrow, which can vary from a few thousand dollars to more than $10,000 depending on the size of the mortgage and the fees associated with the refinance. It is helpful to have cash available to pay the closing costs, but you may also be able to wrap in the closing costs in with the new mortgage.

Questions to ask yourself before refinancing

How long do I plan to stay in this home? If you’re only planning on living there for a few more years, the cost of refinancing may not be worth it. You’ll want to calculate your break-even point: how many months you need to remain in your home before the monthly savings on the new loan exceed the closing costs you’d have to pay. 

How much equity do I have currently? As you make mortgage payments and your home’s value changes over time, the amount of equity you have in the home (put another way, the percent of the home you actually own) will also change. Many lenders prefer you have at least 20% equity in your home before you refinance. Some will approve you with less, but you may not get the most favorable terms.

Am I currently paying for PMI? If you have an FHA loan with Private Mortgage Insurance (PMI) and now you have at least 20% equity, refinancing to a conventional loan can allow you to drop the monthly PMI payment. You may also be able to get rid of PMI by having the home reappraised, which is much more affordable than refinancing. Be sure to consult with your current mortgage lender about the different options available if this is your primary reason for refinancing.

How close am I to completely paying off my current mortgage? The longer you make loan payments, the more each payment is applied to the loan’s principal rather than the interest. That means your first few mortgage payments mostly go to interest, while the last few mostly go toward the principal. If you’re within a decade or so of paying off your mortgage, refinancing becomes less compelling. Why seek to save on interest when you’re actually mostly done paying it off? 

What mortgage terms would I qualify for now? If your financial situation has improved significantly since you first bought your home (such as paying off a large amount of debt, a large increase to your credit score, a big pay bump, or a windfall) it might be in your best interest to refinance so you can shorten your loan term from a 30-year rate to a 15 or 20-year mortgage at a lower interest rate. If you can lower your interest rate and cut the loan term by several years, it could result in saving tens of thousands of dollars in interest over the life of the loan.

How to get started

Refinancing is a lot like applying for your original mortgage. Start your research online and also ask friends for referrals. The first step is to apply for a refinance with a few different lenders (do this within two weeks to avoid multiple credit inquiries, which can lower your credit score). Then, if you choose one of the refinance options, you’ll work with that lender to lock in the rate and go through the underwriting process. Once that’s complete, you’ll pay closing costs, sign the necessary paperwork, and begin making your new mortgage payments.