When Should You Refinance Your Mortgage?

Borrowers tend to think about refinancing their mortgage when interest rates are falling. But there are actually a few reasons why it may be the right time to swap your old loan for a new one. There are a few different refinancing options, each with their own pros and cons.

Here’s how to determine when refinancing makes financial sense and when you’re better off exploring other options.

When should you refinance your mortgage?

When deciding if refinancing is right for you, your current mortgage interest rate is probably your first consideration. But there are other factors to consider in the decision beyond the interest rate itself. Bill Packer, chief operating officer at reverse mortgage lending company Longbridge Financial, LLC, outlines three factors to consider:

1. Monthly after-tax savings (new payment after tax break vs old payment)
2. Time you plan to be at home
3. The cost of getting a new mortgage

Once you know those three things, Packer says you can calculate the return and see if it’s positive.

Reasons to refinance your mortgage

For many borrowers, refinancing is a good idea if you can lower your interest rate and plan to stay in your home long enough to recoup the closing costs of refinancing.

Here are some key reasons to consider refinancing:

Lowering interest rates

If interest rates have fallen since you first took out your mortgage, you can lower your interest rate by refinancing your rate and term. Ideally, that rate should be 0.5 to 0.75 percentage points lower than your current rate.

You may also be eligible for a better interest rate if your credit score has improved since you took out your current loan, so check your score and credit report before applying. The best rates for refinancing your mortgage are available if your score is at least 740.

pay a large amount

A cash-out refinance allows you to tap into the equity in your home and get instant cash. These funds can be used for any purpose, including:

• Reducing or paying off high-interest debt
• Home renovation
• Paying for college tuition fees
• Real Estate Investment

Eliminate private mortgage insurance (PMI)

If your home’s value has risen and your equity ratio has increased, you can refinance your conventional loan and get out of paying private mortgage insurance (PMI) right away, or at least sooner.

Change the loan structure or term

If you haven’t yet paid off your 30-year mortgage and want to pay it off faster, you can refinance to a shorter loan term, such as 15 years, which will also save you money on interest.

Similarly, if your adjustable rate mortgage is due to reset and enter an adjustable rate period, you can refinance to a fixed rate loan to ensure predictable monthly payments.

When not to refinance

There are times when refinancing may not be the best option: In general, refinancing may not be wise for the following reasons:

• You’ll splurge on discretionary purchases: Don’t fall into the trap of sacrificing your home in order to use your savings or cash proceeds from refinancing your mortgage for one-time expenses like a vacation or a car — it’s generally better to save up for these expenses.
• The mortgage payment is well underway. If you’re more than halfway through your loan term, refinancing is unlikely to save you money: You’re already putting more of your payment toward your loan principal than toward interest, so refinancing now would mean restarting your payments and paying more interest.
• Other financial goals will also be undermined: Paying off your loan early is often okay, as long as you’re not neglecting important financial goals like your emergency fund or retirement savings.
• You will end up paying more interest: If your credit score or debt-to-income ratio isn’t great, or may have deteriorated since your original loan, you may be offered a higher interest rate when you refinance — which will, of course, make the overall cost of the loan higher.
• I plan to sell my house soon. If you sell quickly, you probably won’t stay in the house long enough to recoup the costs of refinancing (which is why calculating your breakeven point (see below) is important).

When not to refinance

There are times when refinancing may not be the best option. In general, refinancing may not be wise if:

• You’ll splurge on discretionary purchases: Don’t fall into the trap of sacrificing your home in order to use your savings or cash proceeds from refinancing your mortgage for one-time expenses like a vacation or a car — it’s generally better to save up for these expenses.
• The mortgage payment is well underway. If you’re more than halfway through your loan term, refinancing is unlikely to save you money: You’re already putting more of your payment toward your loan principal than toward interest, so refinancing now would mean restarting your payments and paying more interest.
• Other financial goals will also be undermined: Paying off your loan early is often okay, as long as you’re not neglecting important financial goals like your emergency fund or retirement savings.
• Higher interest rates apply: If your credit score isn’t that great, or your current interest rate is significantly higher than when you took out your mortgage, refinancing could increase the overall cost of your loan.
• I plan to sell my house soon. If you sell quickly, you probably won’t stay in the house long enough to recoup the costs of refinancing (which is why calculating your breakeven point (see below) is important).
• Your current mortgage has prepayment penalties: The penalty is considered a cost of refinancing and should be assessed like any other cost, and although it is a one-time charge, it will affect how quickly you can recoup your refinancing costs.

How much can you save by refinancing?

The amount you can save by refinancing will depend on several factors, including closing costs and whether you choose the right refinancing method for your needs.

For example, if you refinance to a $250,000 loan and your closing costs are 2 percent of that, you’ll owe $5,000 at closing. You won’t see the benefit of refinancing until you reach your break-even point (the point at which the amount you save exceeds what you spent on refinancing, taking into account closing costs, upfront costs, etc.).

To determine your break-even point for refinancing, divide your closing costs by the amount you’ll save each month with your new payment.

Let’s say you’ll save $150 per month by refinancing, and your settlement costs on the new loan are $4,000.

So if you pay off your new loan today, it will officially pay for itself two years and two months from now. If you stay in the home for five years after refinancing, your savings will total $9,000, which is a really big deal.

To calculate how long it will take you to recoup the costs of refinancing your mortgage, use our refinance break-even calculator If you think you might sell your home before you break even, refinancing might not be worth it.

Example: Deciding when to refinance your mortgage

For example, say you take out a 30-year mortgage for $320,000 with a fixed interest rate of 6.23 percent. Your monthly payment will be $1,966. Over the life of the loan, you’ll pay approximately $707,901, of which $387,901 is interest.

Now, let’s say you’re about 15 years into your loan and have paid $86,551 in principal and $257,499 in interest. You want to refinance the remaining principal balance of $233,449 into a new 15-year fixed-rate loan at 5.11 percent.

With the new loan, your monthly mortgage payment will be reduced to $1,859, freeing up $107 in your monthly budget. The amount you will pay over the life of the loan will be $334,756, of which $101,307 is interest. Add in the $344,050 in principal and interest paid on your previous mortgage, and your total costs will be $678,806.

Refinancing will not only lower your monthly payment, but it could save you around $30,000 in the long run.

Is refinancing worth it?

If refinancing gives you more room in your monthly budget, reduces the overall cost of your loan, or helps you achieve other financial goals, then refinancing may be worth the effort and expense.

“It’s important to figure out your break-even point,” says Linda Bell, senior writer at Bankrate. “Remember, like a regular mortgage, refinancing has costs. Even if your goal is to shorten the loan term or lower your interest rate, it might not make financial sense if you plan to sell the home in a few years. Make sure the benefits outweigh the costs.”

Frequently asked questions about refinancing your mortgage

Additional reporting by Ashley Tilford