Is Refinancing Worth It?
Certified Financial Counselor
Ashley Altus is a writer and certified financial counselor through the National Association of Certified Credit Counselors.
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For most households, a mortgage payment is their biggest monthly expense. A monthly mortgage payment can include the principal due on the amount you borrowed and interest payments. In some cases, you may also owe money for private mortgage insurance (also called PMI), or have the cost of your property taxes and homeowners insurance set up as part of your monthly payments.
The point is: Your loan terms and conditions can greatly impact your personal finances. So the thought of refinancing to save money may have crossed your mind.
Mortgage refinancing may have caught the attention of borrowers seeking lower monthly payments or lower interest rates. But before you start fielding calls from lenders, you’ll want to do some research to determine if refinancing will actually help you get closer to your financial goals.
What is a Mortgage Refinance?
In simple terms, a mortgage refinance exchanges your original loan for a new one.
In the refinance process, the new lender will pay off the balance of your initial loan. Then, they’ll issue you a new loan based on the amount you’re borrowing. You will begin to make regular monthly payments on the new loan amount.
Is a Cash-out Refinance the Same as a Mortgage Refinance?
During the cash-out refinance process, you’ll replace your current loan with a new loan. This new loan will have a larger balance than what you owed on your original mortgage. The lender will give the borrower the difference between the amount owed on the old loan and the new loan as cash.
With a standard mortgage refinance, the borrower is typically trying to lower the amount of their monthly payments and potentially take advantage of a lower interest rate.
When Should You Refinance a Mortgage?
Whether you choose to refinance will depend on your financial goals. There are two influences that play a big role in a refinancing decision — your finances and the current mortgage market.
1. Your Credit Profile or Finances Improve
For a borrower who has had a significant improvement to their credit score or overall financial situation, the mortgage refinancing process may open the door to better loan terms.
For example, perhaps you’ve recently paid off all of your high-interest debt (such as credit cards or student loans), which has substantially shrunk your debt obligations. With a stronger credit report than when you initially applied for a mortgage, you may be eligible for a lower interest rate or better loan terms.
2. Market Conditions are Favorable to Borrowers
No one can perfectly predict mortgage rates. But, if the economic conditions fluctuate in your favor, it may serve as the push you need to refinance.
Let’s look at the following use case: During the COVID-19 pandemic in 2020, mortgage interest rates plummeted. For the first time in decades, the interest rate for a 30-year fixed rate mortgage fell below 3%, according to the Federal Reserve Bank of Boston. Many borrowers took advantage of these lower rates by refinancing their existing mortgage.
4 Steps to Refinance Your Mortgage
Similar to the process of buying a home, refinancing requires the borrower to complete a few steps, such as finding the best lender for your situation, completing a loan application, submitting financial documents, and going through the home appraisal process again.
Here are a few steps you can expect to go through when applying for your new mortgage loan.
Step 1: Shop and Compare With Lenders
Remember back when you shopped around for your original mortgage loan to find favorable terms? You’ll do the same with a mortgage refinance, as you may choose to refinance with a different lender than your current one. Gather and review the loan estimates from a variety of mortgage lenders to understand the potential savings with a refinance.
Step 2: Understand the Costs of Refinancing
Refinancing a loan will cost you — so you’ll have to see if it’s actually worth the hassle by calculating your break-even point. For example, if the refinance is going to save you less money in the long term than the cost of going through the process, it may not be worth it.
During the refinancing process, borrowers will typically need to pay for closing costs, which include expenses like origination fees and a credit report fee. You could use a refinance calculator for an estimate.
Step 3: Prepare Your Loan Application
Once you’ve decided on a lender and determined a refinance makes financial sense, you’re ready to apply for the loan. The application process should feel familiar to you.
Step 4: Close on the Refinanced Loan
In this step, you’ll review your final loan documents closely and sign the final paperwork that solidifies that the loan process is complete.
3 Common Goals When Refinancing
Below are three common reasons that you may decide to refinance:
1. Lower Your Monthly Payments
There are a couple factors that could allow you to lower your monthly loan payment with a refinance:
If interest rates have fallen from the time when you first bought your home, you may consider refinancing to score a lower interest rate. This will not only help you save money on your monthly payment, but it will also lower the total amount of interest you pay over the life of the loan.
Another way is through a longer loan term. For borrowers with a 15-year mortgage term, they may consider switching to a 30-year loan. While this option will cost you more money in the long run, this financial decision could help boost your monthly savings.
2. Decrease your Loan Term
If you have a 30-year mortgage but want to pay off your loan sooner and decrease the interest you’ll pay, you may consider a refinance option focused on changing to a 15-year loan. One downside to a shorter loan term is that you may see your monthly payment increase.
3. Switch From an Adjustable-Rate Mortgage to a Fixed-Rate Mortgage
Adjustable-rate mortgages fluctuate based on market conditions. If rates are low, this loan type can benefit you, but on the flipside, if rates skyrocket, monthly payments may start to get expensive. Refinancing to a fixed-rate mortgage can help borrowers feel more secure with a consistent monthly payment.
4 Factors to Consider When Thinking About Refinancing
1. Your Future Plans
Refinancing a mortgage costs time and money. As you are taking out a new loan, many lenders will require you to pay for closing costs and fees. If you have plans in the near future to move, it may not be worth it, as you won’t be able to reap the benefits of refinancing.
2. The Value of Your Home
Homes fluctuate in value based on market conditions. If the home value has decreased from the time you bought it, it could be challenging to find a loan with more advantageous terms and conditions.
3. Your Credit Score
Just like how your credit history mattered when you took out your initial mortgage, it’s also a consideration when you refinance a loan. Review your credit report to ensure your credit profile is in a strong place.
4. Prepayment Penalty
Some mortgages have prepayment penalties. A prepayment penalty is the amount a homeowner would have to pay if they refinanced their loan or paid it off earlier than expected. Review your loan documents to see if your loan has a prepayment penalty attached to it. Calculate the break-even point to see if the penalty may be worth paying.
The Bottom Line
Some homeowners may truly benefit from a mortgage refinance. While a refinance may give you a lower monthly mortgage payment, many of the other costs of homeownership will stay the same. For those with a fixed-rate mortgage, you’ll want to determine if current interest rates are lower than your initial rate before you make the jump.