When to refinance your mortgage

Refinancing can get you better rates and lower mortgage payments, but it comes with its own set of costs.

Elissa

Elissa Suh

Published March 6, 2020

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KEY TAKEAWAYS

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

  • Most people refinance to get lower interest rates, but refinancing is also helpful if you want to change the loan term or type

  • A refinance loan comes with fees, but when mortgage rates are low enough, it can be worthwhile

  • If you’re considering a refinance, examine your long-term financial goals and potential monthly savings

When you refinance your mortgage, you pay off your old loan (your current mortgage) using a new loan (the mortgage refinance). Then you simply repay this new loan, which hopefully has better terms.

One of the main reasons why people think about getting a refinance is to get better rates — either because their financial circumstances have improved or the current economic climate has led to lower average mortgages. But there are other benefits to refinancing your mortgage, like getting a shorter loan term or changing the type of loan, like switching from an adjustable-rate mortgage (ARM) to a fixed-rate one. You can also receive a part of your home’s equity as cash.

Refinancing a mortgage can lead to a lower or higher monthly mortgage payment, depending on your goals. Generally, refinancing saves you money in the long term — but the up-front costs (you'll have to pay closing costs again) could cancel out any monthly savings or delay them too far in the future to make a difference. That’s why it’s key to look at your long-term financial goals and do some cost comparison before refinancing to see if it’s worth it for you.

We’ll take a look at when and why someone should refinance a mortgage.

In this article:

Reasons to refinance a mortgage

Here are some common benefits and reasons to refinance:

1. Get a lower interest rate

One of the primary reasons people think about refinancing is to get a lower mortgage rate. A lower annual percentage rate (APR) generally means a lower monthly payment.

We’ll talk about refinance rates in-depth in the next section. But in the meantime you can plug different interest rates into our Policygenius Mortgage Calculator to see a hypothetical monthly payment schedule.

2. Change the loan term

If you switch to a mortgage with a shorter loan term, like going from a 30-year term to a 15-year term, 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. A longer term typically means making smaller mortgage payments, because you’re dividing the mortgage principal across more years. A shorter term could mean paying less interest, since you’re paying off the principal faster.

3. Change the type of mortgage you have

Refinancing allows you to convert 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 mortgage ARM rates keep increasing; you might want to switch to an ARM if the fixed rate is higher than the market rate.

4. Get cash

When you refinance your mortgage, you can take out a loan for more than what you borrowed and convert 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 a cash-out refinance here.

5. Get rid of private mortgage insurance

If you made a down payment of 20% or less, lenders typically require you to pay mortgage insurance (PMI) in addition to your monthly mortgage payments. You can stop paying these insurance premiums based on your loan-to-value ratio and equity. When you have an 80% LTV ratio or 20% equity on your home, you can ask the lender to remove PMI. When you have 78% LTV and 22% equity, the lender is typically required to cancel PMI. Refinancing might help you achieve this.

If you have an FHA loan (a mortgage backed by the federal government), you can’t remove mortgage insurance premiums except by refinancing your mortgage. You’ll need to refinance the FHA loan into a conventional loan instead, the only way to eliminate the insurance premiums on an FHA mortgage.

Refinancing does not get rid of homeowners insurance, which protects your home from hazards like structural damage and theft. If your homeowners insurance premiums have increased, you can reshop your policy. (Policygenius can help you compare quotes.)

When to refinance a mortgage

Now that you know why someone might consider refinancing a mortgage, here’s when it’s best to do so.

Mortgage rates are low

You’ll hear a lot about mortgage rates in the news, especially if they sharply rise or take a drastic plunge. Mortgage rates are largely tied to economic factors and when the market rates dip below your mortgage rate, most people start to think about refinancing. However, even if the average mortgage rates are low, the exact rate offered to you by mortgage lenders depends on a few more factors (which we’ll talk about next).

You can read analysis of today’s mortgage rates updated on a weekly basis here.

Mortgage lenders may advertise “refinance rates,” but know that they are the same thing as mortgage rates, since refinancing simply means taking out a new loan.

Your personal finances have improved

Before you decide whether to refinance your mortgage, take a look at your credit score. If your FICO score has increased since you first took out the mortgage, then you may be offered a lower interest rate when you refinance.

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.

However, refinancing your mortgage to get a better interest rate may not necessarily result in savings, especially after factoring in closing costs and the new term length. We’ll discuss this in the next section.

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How much does a mortgage refinance cost?

A major downside to refinancing a mortgage is that you’ll pay many of the same closing costs again. Traditional mortgage closing costs are estimated to be anywhere from 2% to 5% of the mortgage loan amount — but you will likely pay less closing costs for a refinance, especially if you stick with the same lender. For example, you can expect to pay lender fees like a loan origination fee, but other costs like prepaid expenses probably wouldn't apply in this situation.

Even still, costs might reach into the thousands of dollars, so for some people that may offset the benefits of refinancing. Some lenders may offer a no-fee refinance, but in reality they’re rolling the cost into your loan and increasing the loan amount. Make sure you ask the loan officer to confirm the terms.

Learn all about closing costs.

Is refinancing worth it?

Let's say you took out a 30-year fixed-rate mortgage with a 6.35% interest rate for $450,000. You’ve been making a monthly payment of $2,800 for ten years and have a remaining loan balance of about $380,000.

If you refinance today to a new 30-year loan (for the remaining $380,000 loan balance) with a fixed rate of 3.65%, you’ll have a new monthly payment of $1,740.

That’s a monthly savings of $1,060. But it doesn’t take into account the closing costs.

Let’s say the closing costs are $6,000, a little less than 2% of the loan amount. To figure out when whether you’d save money, you need to calculate your breakeven point.

Take the closing costs and divide them by the savings: $6,000 closing costs / $1,060 in monthly savings = 5.66. That means you would break even after six months.

How do I refinance my mortgage?

To refinance, first shop around for the lender who has the most agreeable mortgage 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 your current lender 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. Get preapproved, compile any necessary documents, including tax returns, and apply.

Learn more about the mortgage process.

When refinancing is a bad idea

If you plan to sell your home in the near future then refinancing can be a bad idea. Refinancing reaps long-term financial savings — you must wait months or years before you break even, as we mentioned before. People looking for a new primary residence might put their search on hold.

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 monthly payments. It is difficult for a borrower who is struggling to make the monthly payments, or has missed payments, to qualify for mortgage refinancing in the first place, since the lender will check your debt-to-income ratio and credit score. Additionally, the borrower may not have the necessary cash to cover the refinance closing costs.

Instead, it might be better to cut down on spending, and create a plan to pay off your current loan. (Learn how to pay off a mortgage in five years.)

Cash-out refinancing is a bad idea if you already have trouble managing your debt. Some people may intend to use the cash to pay off credit card debt, which usually has a higher interest rate, and then focus on paying down the refinanced mortgage. However, taking on new debt to pay off older debt is not recommended, unless you’re certain that you’ll keep your spending in check.

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About the author

Personal Finance Editor

Elissa Suh

Personal Finance Editor

Elissa is a personal finance editor at Policygenius in New York City. She writes about estate planning, mortgages, and occasionally health insurance. In the past she has written about film and music.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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