How to refinance your mortgage

A new loan with better rates can help pay off your current mortgage, but it comes with its own set of costs.

Elissa

Elissa Suh

Published October 15, 2019

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KEY TAKEAWAYS

  • Refinancing your mortgage means taking out a new mortgage to pay off your old one

  • Benefits to a refinanced mortgage might be a lower interest rate or shorter loan term

  • You can also change the loan type or get rid of mortgage insurance

  • A refi isn’t financially wise for everyone; you have to pay fees and closing costs, which can be very expensive

When you refinance your mortgage, you pay off your old loan (your current mortgage) using a new loan (the mortgage refinance) with better terms. The benefits to refinancing your mortgage might be a more favorable interest rate or a shorter loan term. You can also receive a part of your home’s equity as cash, or change the loan type (switch from an adjustable rate to a fixed rate).

A mortgage refinance can result in lower or higher mortgage payments, depending on your goals. Generally, refinancing saves you money in the long term — but the up-front costs (lender fees, taxes and insurance) could cancel out any savings or delay them too far in the future to make a difference.

However, if your credit score has improved since you originally took out your mortgage, or you earn considerably more money, or if your home has increased in value, then refinancing may make sense for you.

In this article:

Reasons to refinance your mortgage

Before you decide whether to refinance your mortgage, take a look at your credit. If your FICO score has increased since you first took out the mortgage, then you might be a candidate for a refi.

You should also calculate your debt-to-income ratio, which measures how much of your debt can be covered by your current income. If your debt-to-income ratio is more favorable than it was at the beginning of your current mortgage, then it might be a good time to refinance.

Here are some common benefits and reasons to refinance:

1. You can get a lower interest rate

If your finances have improved, you may find that lenders are willing to offer you a lower interest rate. For example, let's say that you’ve been paying off your 30-year, fixed-rate mortgage for 10 years and still have a $250,000 loan balance at a 5.0% interest rate.

If you refinance to a new 30-year loan of $200,000 with a fixed rate of 4.8%, you’ll save $72,368 over the lifetime of the loan, accounting for about $6,000 in fees.

As you can see, paying a lower interest rate can save you a lot of money over the entirety of the loan term, but you need to take closing costs into consideration. (However, it will take you almost 20 years to break even compared to simply paying off the original loan balance.)

Use this Policygenius Mortgage Calculator to see how much you can save from refinancing your home loan.

2. You can shorten the loan term

If you switch to a mortgage with a shorter loan term, like going from a 30-year to a 15-year, you can pay off your mortgage faster. While 30-year mortgages are the most common type, you can generally ask your lender for any term length. Keep in mind that when you refinance, the loan term resets and the clock starts at year 0. You don’t get back the years you spent paying off the original mortgage.

3. You want to convert your mortgage

Refinancing allows you to convert from one type of mortgage to another. For example, you can switch from a fixed-rate mortgage to an adjustable-rate mortgage (ARM). Fixed rate means the interest rate stays the same over the entirety of the loan term, while an adjustable rate means that the percentage rate can fluctuate.

You might want to switch to a fixed-rate loan if your ARM’s interest rates keep increasing; you might want to switch to an ARM if the fixed annual percentage rate is higher than the market rate.

4. You need cash

When you refinance your mortgage, you can take out a loan for more than what you borrowed and convert a part of it into cash. This is called a cash-out refi and while it increases the amount of principal you have to pay over time, it can help you get out of a short-term bind.

Learn more about if a cash-out refinance is right for you.

5. You want to get rid of mortgage insurance

If you made a down payment of 20% or less, lenders typically require you to pay mortgage insurance premiums (PMI) in addition to your monthly mortgage payment. You can get rid of your PMI based on your loan-to-value ratio and equity — you typically need 78% LTV and 22% equity for the lender to cancel PMI. Refinancing might help you achieve this.

If you have an FHA loan (a mortgage is backed by the federal government), it is more difficult to get rid of your mortgage insurance — and you might even be required to pay it for the entire lifetime of your loan, even as the home gains more equity. Refinancing your mortgage is the only way to eliminate these costly insurance premiums. In order to be eligible, you must have gained at least 20% equity on your home.

How much does a mortgage refinance cost?

A major disadvantage to refinancing a mortgage is that you’ll pay many of the same closing costs that your original mortgage had, including lender fees, taxes and insurance. These costs can reach into the thousands of dollars, so for some people that may offset the benefits of refinancing.

Refinancing closing costs are estimated to be as high as 6% of the loan amount.

Some of the fees involved in a refinance include:

  • Application and processing fee
  • Credit check fee
  • Loan origination fee
  • Underwriting fees
  • Taxes

While some lenders may offer a no-fee refinance, this might only mean no fees up front. The costs will still be rolled into your monthly mortgage payment.

How do I refinance my mortgage?

To refinance, first shop around for the lender who has the most agreeable rates. You can also ask about their closing costs, although certain costs will vary between people of different financial backgrounds. You don’t need to use the same lender who wrote your original mortgage and there may not be any benefits to doing so.

Next, figure out the value of your home — you may want to get a real estate appraisal. If your home has increased in value, you could be eligible for more favorable refinancing terms.

You can use this information to calculate your home’s equity. Subtract your remaining mortgage balance from the current market value of the home to figure out how much equity you have. The greater the value of your home, the greater equity you have.

To apply for a mortgage refinance, follow the same steps as you would to apply for a mortgage:

  1. Get prequalified or preapproved
  2. Compile your documentation, including financial information and tax forms
  3. Apply
  4. Get processed and go through underwriting
  5. Receive closing disclosure document and sign the agreement

When refinancing is a bad idea

While refinancing can help you save money or pay down a mortgage faster, it’s actually most useful for borrowers who already have a strong financial situation and keep up with their payments. People whose finances haven’t improved since taking out their original mortgage or who are struggling to repay their monthly mortgage payments won’t benefit as much, and may even lose money on a refinance.

Some reasons not to get a mortgage refinance include:

You can’t afford higher payments

Refinancing your mortgage to get a shorter term means you could pay less interest over the period of loan. However, this means that your monthly payments will likely increase to make up for the shorter length of time you have to pay off the principal.

You don’t want to extend your mortgage period

Refinancing your mortgage means taking out a whole new loan. If you’re not explicitly looking to shorten the loan term, you might end up extending it. Consider whether you want to be stuck with an additional 30 years’ worth of mortgage, especially if you plan to downsize your primary residence.

Downsizing may be the better option

Depending on your circumstances, downsizing might be more cost-effective than a refinance.
If your current home has increased in value, you might be able to sell it and downsize to a new one, paying off your old mortgage with the proceeds and keeping any of the remaining profit.

You’re struggling to repay your mortgage

There are a lot of reasons why a borrower might fall behind on their mortgage payments. They may have had to cover other unexpected expenses, or experienced a drop in income. In this case, it may be very difficult to receive a refi in the first place because banks will request to see your debt-to-income ratio and credit score. Additionally, you’ll need liquid cash that you may not have to cover refi’s closing costs.

Instead, it might be better to cut down on spending and create a plan to pay off your current loan. Read about how to pay off a mortgage in 5 years.

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