At some point after you buy a home, you might consider refinancing your mortgage to meet a financial goal. Whether it’s to lower your rate, pay off your loan earlier, tap home equity or switch loan types, mortgage refinancing can be beneficial to your budget and your housing bottom line.
Refinancing isn’t free, however, so figure closing costs — and available interest rates — into your decision. Before you dive in, it’s also important to understand how refinancing a mortgage works, when it makes the most sense and the steps involved.
What is mortgage refinancing?
A mortgage refinance is when you pay off and replace your existing home loan with a new one. Many homeowners refinance to get a lower interest rate, shorten their loan term or meet another financial goal.
“You should refinance when you’re not forced to do it but, rather, to improve your financial situation,” said Edwin Santiago, branch manager with Fairway Independent Mortgage Corporation in Wayne, Pennsylvania. “It comes down to figuring out what your goals are and if the math works.”
When interest rates fall across the market, many homeowners who bought their homes at higher rates rush to refinance and save money on their payments. Some even shorten their loan term to snag a lower rate and zero their balance faster. When rates are higher, though, refinance demand tends to soften as fewer homeowners will benefit.
How does refinancing work?
When you refinance a mortgage, you pay off and replace your current mortgage with a new loan, ideally with more favorable terms. Unless you’re doing a cash-out refinance to tap some of your home’s value (more on that later), you won’t receive funds when you close on your new loan.
You’ll pay some of the same costs to close the refinanced loan (more detail below) as you did for your original mortgage. Just like the first time around, your lender will check your credit, finances and employment to ensure you can afford the new loan. Your lender will also help you calculate potential refinance savings.
You’ll also need a home appraisal to get a refinance. This gives the lender an unbiased opinion of your home’s market value to ensure it’s worth the amount you’re borrowing. The median cost of an appraisal is $500, according to a 2022 report from the National Association of REALTORS®.
When it may be wise to refinance your mortgage
Refinancing should improve your financial situation in some tangible way, such as lowering your rate or getting out of a variable-rate loan.
- Get a lower interest rate: When mortgage rates drop, refinancing a loan to one with a lower rate might save you money on monthly mortgage payments and lower your overall interest costs. (Try a refinancing calculator like Calculator.net’s to estimate your potential savings.)
- Change your loan term: Shortening your mortgage loan term (say from 30 years to 15 years) means you’ll pay off your loan faster and, potentially, get a lower rate. Conversely, you might opt to lengthen your loan term if you need to lower your monthly payments. However, this will cost you more in interest over the long term.
- Put a mortgage into one borrower’s name: If you’re getting a divorce and plan to stay in the home, or you inherited property and want to buy a family member out of their share, you may want to refinance a mortgage into your name. Shannon Hoff, a senior mortgage advisor with American Pacific Mortgage in Roseville, California, said she has seen increased refinance activity in 2023 as more couples divorce due to financial strains. When one person in the relationship wants to keep the house, they’ll do a cash-out refinance to buy out their spouse’s share of the equity and put the new loan into their name, said Hoff.
- Tap home equity for financial goals: A cash-out refinance replaces your current home loan with a new, larger mortgage that allows you to withdraw the difference between what you owe and your home’s value in cash. You can use the money to pay for home renovations, consolidate high-interest credit card accounts, buy real estate or achieve another financial goal. (You might also consider a home equity loan in this instance, particularly if refinancing rates aren’t appealing.)
- Switch from an ARM to a fixed-rate loan: Refinancing from an adjustable-rate mortgage (ARM) into a fixed-rate mortgage before the ARM resets to a variable rate might save you money if your payments are slated to increase and become incompatible with your budget.
- Drop FHA mortgage insurance: If you took out a home loan guaranteed by the Federal Housing Administration (FHA), you’re likely paying annual mortgage insurance premiums, which are repaid over the life of the loan. Once you reach 20% equity in your home, refinancing into a conventional loan allows you to drop mortgage insurance altogether.
Reasons to not refinance your mortgage
There are some scenarios where refinancing could be a riskier bet.
- Tap equity for “wants” instead of “needs”: Using a cash-out refinance (or home equity loan, line of credit) to make big luxury purchases or to go on vacation isn’t advised, as you’re putting your home at higher risk of foreclosure and depleting your home equity without any net benefit.
- Improve short-term cash flow: If you’re struggling to pay other monthly bills, you might see cash-out refinancing as the solution. Given its costs, however, refinancing shouldn’t supplement cash flow or income as a short-term need. If you’re struggling with your financial situation, a certified credit counselor or financial advisor can help you come up with a plan to get you back on track. (You might start with the Department of Justice’s list of approved credit counseling services.)
- Following fellow homeowners’ advice: You might hear neighbors or friends talk about refinancing, but their “why” may not make financial sense for your situation. Contact a mortgage lender to ask about refinancing and explore options if you think you might benefit.
What are the different types of mortgage refinancing options?
Mortgage refinancing comes in different forms, and one of them may suit your situation better than others.
| Refinance type | What it is | How it helps |
|---|---|---|
Rate-and-term refinance | Replacing an existing loan with a new mortgage, often with a lower rate or different loan term (longer or shorter). | Lower your interest rate and/or monthly payments, or to pay off your mortgage in less time. |
Cash-out refinance | Replacing your existing mortgage with a new, larger loan, and withdrawing the difference between what you owe and your home’s value in cash. | Tap your home equity for home improvements or to consolidate high-interest debt, pay education expenses, buy other real estate or achieve other goals. |
Cash-in refinance | Similar to a mortgage recast, your lender makes changes to your loan terms and resets the repayment schedule after you make a large lump-sum payment at closing. | Pay off your home faster and lower your monthly expenses if you receive a windfall, such as an annual bonus or inheritance. |
How much does refinancing cost?
Refinancing a mortgage typically costs 2% to 6% of the loan amount. Freddie Mac estimates that most refinance closing costs average about $5,000, but the figure varies by location, loan size and loan type. For example, if you refinance a $300,000 loan balance, you could be on the hook for $6,000 to $18,000 in closing costs.
Calculate your break-even point
Before you finalize a mortgage refinance, estimate your break-even point. This is the length of time it’ll take to realize savings from refinancing after accounting for closing costs.
Use the following equation:
- Refinancing costs / Monthly savings = Number of months to break even
So if your closing costs are $6,000 and refinancing would save you $300 on your monthly payment, you’d break even after 20 months ($6,000/$300=20 months).
Then, consider how long you plan to own the property. If it’s longer than 20 months in the above scenario, then refinancing could be wise. But if you plan to sell your home in the next year, for example, refinancing may not be worth it.
No-closing-cost refinance
Some lenders offer a “no-closing-cost refinance” so you don’t have to pay closing costs upfront. Instead, the lender pays the fees at closing on your behalf and charges you a higher rate to recoup their expenses.
Before refinancing a mortgage with no closing costs, compare your current monthly dues with what’d you owe on the refinanced loan.
Evaluating the costs and benefits of refinancing
During the COVID-19 pandemic, mortgage rates hit record lows, and many homeowners clamored to get a 2% or 3% mortgage APR. By Nov. 9, 2023, however, mortgage rates hit 7.50%, according to Freddie Mac.
While the urgency to refinance to snag rock-bottom rates has long been over, there are still homeowners who need to refinance for various reasons.
Santiago noted that cash-out refinancing has gained steam as more cash-strapped households get deeper into credit card debt. As of the second quarter of 2023, American households owed more than $1 trillion in credit card debt, according to the Federal Reserve Bank of New York.
Getting a cash-out refinance, even at today’s higher rates hovering above 7%, can help you consolidate high-interest credit card debt. This enables you to spread out housing payments over a longer period, which helps preserve cash flow, Santiago said. If you go this route, though, plan your future spending so that you don’t rack up credit card debt all over again.
“We’re in a market environment and economy where a lot of households are maxing out on their consumer debt, so they’re running out of options and looking for relief somewhere,” Santiago said.
For your situation, consider your “why” for refinancing and do the math (mentioned above) to ensure the savings outweigh the costs on your preferred timetable.
Steps for refinancing a mortgage
Like borrowing a home loan, mortgage refinancing is an involved process. Here’s what to expect:
- Find out your home’s value and calculate your equity. Property search websites (like Zillow and Trulia) can provide estimates, or you can contact a local realtor for a free opinion of your home’s value. To calculate your equity, subtract your remaining mortgage balance from your property’s estimated value. If you have $200,000 left on your loan for a house worth $300,000, for example, you have $100,000 (or 33%) in equity. If you have less than 20% equity in your home, you might consider pausing your refinancing application.
- Check your credit score and report. The higher your score, the better your rate offers will be. Also, correct any errors on your credit report, or they could impact your refinance approval. AnnualCreditReport.com is a good starting point.
- See if your current loan has a prepayment penalty. This should be outlined in your original mortgage documents, or you can contact customer service to ask. Take this into account as part of your cost-benefit analysis.
- Shop around to compare rates, terms and products. Many of the best mortgage refinancing lenders offer rate quotes (without a hard credit check) and list their product information online. Review at least several lenders, perhaps including your current home loan provider, before zeroing in on a favorite.
- Gather documents and apply. You’ll need the same documents you provided for your original mortgage, such as recent federal tax returns, bank statements, pay stubs and a listing of assets and liabilities. When you apply for refinancing, you’ll get a loan estimate outlining details of your new loan, including your monthly payment, interest rate, fees and other key information. Ask questions about any items that are unclear or costs you don’t understand.
- Get a home appraisal. Some lenders use an automated appraisal while others will have a professional appraiser perform one in-person. Request a copy of the appraisal and, if the appraisal is lower than expected, consider appealing it.
- Close on your new loan and start making your payments. Keep in mind your loan servicer may not be the same lender you close with, as loans are often resold to different companies. Confirm your first payment due date and consider enrolling in automatic payments to ensure you stay on track.
How to find the best mortgage refinance rates
To find the best refinance rates, shop around and apply with at least three to four different lenders. You can check with your current mortgage company, as well as national or regional banks, online lenders and credit unions.
As you browse, make sure you’re comparing similar loan types and loan terms, and pay close attention to the annual percentage rate (APR) of the loan. APR accounts for the interest rate, fees, mortgage insurance premiums and other charges to give you a complete picture of your total loan costs each year.
Also, look closely at the loan estimate each lender provides to find details about your loan, fees, interest rate and other key details. You might also test-drive lenders’ customer service so you end up with the best overall loan.
Frequently asked questions (FAQs)
In most cases, refinancing takes less than 30 to 45 days. This timeline can vary depending on the type of refinance you’re doing, market conditions and your lender’s volume of customers.
While there’s no limit on how many times you can refinance a mortgage, lenders recommend you only refinance to secure some net, tangible benefit. Don’t forget to account for closing costs (and prepayment penalties, if applicable) each time you consider refinancing.
A rate-and-term refinance replaces your existing mortgage with a new loan for the same principal balance, usually at a lower rate or a different loan term. A cash-out refinance is a new, larger loan that replaces your existing mortgage and allows you to withdraw the difference between your home’s value and what you owe in cash.
Lenders typically require an appraisal to estimate your home’s value and, therefore, to estimate your amount of equity. This is especially true for cash-out refinancing; most lenders require you to have at least 20% equity or more to tap home equity (otherwise you’d have to take on private mortgage insurance).
Some mortgage lenders charge a prepayment penalty within the first few years of taking out a mortgage, but not all do. This fee can vary by loan type and lender, but generally starts at 2% of your loan balance if you prepay within the first year. The penalty gradually declines each year until phasing out completely, usually within three to five years. Check with your servicer to see if it charges this fee so you include it in your break-even calculations.
A mortgage refinance is a new loan with a new repayment term, which can initially lower your credit score. But in the long term, refinancing might improve your score. For instance, if you’re using a cash-out refinance to consolidate several high-interest credit cards with significant balances, your credit score should improve over time — as long as you make full, on-time payments toward your new loan.
