When and why you should refinance a home
There are many reasons you might want to refinance a mortgage, and many factors to take into account when you make that decision.
For example, now may be a good time to refinance because mortgage refinance rates are very low. If you lower the rate on your loan, it could save you money. Be aware, the rate you get will depend on your loan, location, credit score, income, and other factors. Not everyone will qualify for the lowest advertised rates.
You'll also need to be sure you will stay in your home for long enough to cover your mortgage refinancing costs. In order for it to be a true money-saving move, you'll break even on your closing costs before you sell or refinance again.
Why you should refinance your home
Mortgage refinancing can be a good idea if it will:
- Lower your interest rate
- Shorten your loan term
- Disentangle you financially from a relationship, like an ex-partner
- Provide the cash you need to make repairs
On the other hand, if you've already been paying down your mortgage for a long time and want to start a new 30-year mortgage to lower your monthly payment you might want to think twice. You'll pay a lot more in interest charges overall if you start the loan term over.
No matter what reason you have for refinancing, it's important to look at the pros and cons of the new loan compared to staying with your old loan.
What are the reasons to refinance?
Here are some of the most common reasons to refinance a mortgage.
Lower the interest rate: If you have a significant number of years remaining on your home loan and can qualify for a lower interest rate, refinancing might make sense.
Lower your monthly payment: A lower rate or longer term could both lower your monthly mortgage payment.
Shorter loan term: You can save money by paying off your home loan more quickly. If you can qualify for a lower interest rate, you may be able to shorten the loan term without significantly increasing your monthly mortgage payment.
Get rid of mortgage insurance: Some borrowers are required to pay a monthly and/or annual fee or mortgage insurance premium. Private mortgage insurance (PMI) on a conventional loan is canceled automatically once you have enough equity. But for other loans (including most FHA loans), the only way to stop paying this extra fee is to refinance to a new loan that does not require it.
Get cash: If you have enough equity in your home, you could do a cash-out refinance. In this instance, you'd borrow more than your current loan balance -- essentially tapping the equity in your home to receive funds in cash. This is one way homeowners pay for major home improvements.
Consolidate debt: According to the Federal Reserve, the average credit card rate in November 2020 was 16.28%. In contrast, Freddie Mac put the average 30-year fixed mortgage rate Jan. 7, 2021 at 2.65%. It might make financial sense for some people to use a cash-out refinance loan to pay off their higher interest debt. (This strategy has a couple of important caveats, so keep reading.)
Consolidating debt doesn't have to be about credit cards. Some borrowers use a mortgage refinance to consolidate other debt, such as a first mortgage and home equity loan or line of credit.
Remove someone from the loan: Sometimes, a co-borrower needs to be removed from the home loan. The way to do this is for the remaining borrower to refinance to a new loan.
Move from an adjustable-rate mortgage to a fixed-rate mortgage, or vice versa: Adjustable-rate mortgages, or ARMs, usually start out at a low, fixed teaser rate and then adjust after a certain period of time. The rate is guaranteed for an initial period, after which it can go up or down periodically along with a benchmark rate. When market rates are very low, it can be a financial advantage to refinance to a fixed-rate loan with a set interest rate.
Right now, interest rates are at rock bottom. As such, few people will financially benefit from taking out an adjustable-rate mortgage rather than a fixed-rate mortgage. However, when interest rates rise again, it could make sense to convert from a fixed-rate mortgage to an ARM. You might save money in the short term if the teaser rate on the ARM is significantly lower than your current mortgage rate and you know you will sell the home or refinance again within a couple of years.
For more on why to refinance your mortgage, read our guide.
When is the best time to refinance?
Traditional wisdom used to be you should only refinance if you could reduce your interest rate by at least 2%. That's no longer true. Some borrowers find they can save money by refinancing even to shave half a percent off the rate. Use our mortgage refinance calculator to help you decide.
The best time to refinance a mortgage is when you can answer yes to both these questions:
- Is there a clear benefit to refinancing now?
- Will you own the property long enough to break even on the refinance costs?
On breaking even: Every mortgage loan has closing costs. And the costs involved in a refinance will be similar to your original purchase mortgage -- usually 2-5% of your loan amount. Freddie Mac puts the average refinance cost at about $5,000. The actual price you pay will depend on your location, loan size, and lender. If you see a no-closing-cost refinance, don't be misled. You'll find the costs are added to the loan balance or the interest rate is higher.
Here's how to calculate when you'll break even on your refinance. Let's say your refinance costs $5,000 and you're able to cut your monthly payment by $150. It would take $5,000/$150 = 33 months to reach your break-even point and recover your costs.
