When Does It Make Sense to Refinance Your Mortgage?

Whenever interest rates drop, or a homeowner's financial situation improves, the same question tends to come up: should I refinance? Sometimes the answer is a clear yes, and refinancing can save thousands of dollars or help you reach an important goal. Other times, the costs outweigh the benefits, or a refinance creates new risks. Understanding how refinancing works, and how to run the numbers, can help you make the right call.

What refinancing means

When you refinance, you replace your current mortgage with a new loan. The new loan pays off the old one, and from then on you make payments on the new loan's terms, which may include a different interest rate, a different length or a different type of loan.

People refinance for several reasons. The most common is to get a lower interest rate, which can reduce the monthly payment and the total interest paid. Others refinance to change the length of their loan, for example moving from a 30-year mortgage to a 15-year mortgage to pay off the home faster. Some switch from an adjustable-rate mortgage to a fixed rate to gain predictable payments. FHA borrowers sometimes refinance into a conventional loan to remove mortgage insurance once they've built enough equity. And some homeowners refinance to take cash out of their home equity.

Refinancing isn't free

A refinance is a new mortgage, and like your original mortgage, it usually comes with closing costs. These can include lender fees, an appraisal, title services and government recording fees. Depending on the loan, these costs can add up to thousands of dollars. Some lenders offer 'no-closing-cost' refinances, but those costs are usually covered through a higher interest rate or by adding them to the loan balance, so you still pay them in another form.

Because of these costs, a lower interest rate alone doesn't automatically make refinancing worthwhile. You need to know how long it will take for the savings to cover the costs.

Find your break-even point

The break-even point is the time it takes for your monthly savings to add up to what you paid to refinance. To estimate it, divide your total closing costs by your monthly savings.

The break-even calculation is a good starting point, but it isn't the whole story. You should also consider the total interest you'll pay over the life of the new loan compared with your current one.

Watch the loan term

One of the most common refinancing pitfalls is restarting the clock. Suppose you've been paying on a 30-year mortgage for eight years, so you have 22 years left. If you refinance into a brand-new 30-year loan, your monthly payment may drop, partly because of a lower rate and partly because you're spreading the remaining balance over 30 years again. But you'd now be making payments for a total of 38 years, and you could end up paying more total interest, even at a lower rate.

There are ways to avoid this. You could refinance into a shorter loan, such as a 20-year or 15-year mortgage, which often comes with an even lower rate. Or you could take a new 30-year loan for flexibility but continue paying the same amount you were paying before, which would pay the loan off faster and save interest.

Cash-out refinancing

A cash-out refinance lets you borrow more than you currently owe on your home and receive the difference in cash. For example, if your home is worth $400,000 and you owe $200,000, you might refinance into a new $260,000 loan and receive about $60,000 in cash, minus closing costs.

Cash-out refinancing can be a lower-cost way to borrow than credit cards or personal loans, because mortgages typically have lower interest rates. Homeowners sometimes use it for home improvements, which may increase the home's value, or to consolidate high-interest debt.

But cash-out refinancing carries real risks. It reduces your home equity and turns that equity into debt secured by your house. If you use it to pay off credit cards and then run up new balances, you could end up deeper in debt, with your home on the line. Lenders also limit how much equity you can take out, often requiring you to keep a certain percentage of equity in the home.

When refinancing often makes sense

Refinancing tends to make the most sense when you can get a meaningfully lower interest rate, you plan to stay in the home well past the break-even point and you're not extending your loan term in a way that significantly increases total interest. It can also make sense when you need to move from an adjustable rate to a fixed rate for stability, or remove mortgage insurance.

Before you refinance

Check your credit before you apply, since a higher score can help you qualify for a better rate. Gather Loan Estimates from several lenders, including your current lender, and compare both the rates and the closing costs. Look at the total cost over the time you expect to keep the loan, not just the monthly payment. And check whether your current loan has a prepayment penalty, which would add to your costs.

Refinancing can be a powerful financial tool, but only when the numbers work in your favor. Taking the time to calculate your break-even point and compare offers can make the difference between saving money and simply trading one set of costs for another.