Should You Refinance Your Mortgage? Understanding When and Why

Refinancing your mortgage can help you lower your monthly payments and reduce the total cost of your loan. It can also free up cash for other financial goals. According to the Federal Housing Finance Agency, over 14% of outstanding mortgages have an interest rate of 6% or higher. But how do you know if refinancing is the right decision? 

Understanding how refinancing works as well as the potential benefits, drawbacks, and costs involved can help you determine whether a mortgage refinance aligns with your needs.

What does it mean to refinance your mortgage?

Refinancing your mortgage involves replacing your existing mortgage loan with a new one, often with a different interest rate, loan term, or loan type. Many banks and lenders offer mortgage refinancing to qualified borrowers. 

Homeowners typically refinance to save money. Depending on your credit and other factors, you could secure a lower interest rate to reduce your monthly payments and the total interest paid over the life of your loan. You can also shorten your loan term, allowing you to pay off your mortgage sooner. Some homeowners apply for a cash-out refinance, which leverages your home's equity to provide additional funds for home improvements, debt repayment or other needs. 

If you're considering refinancing, using a mortgage refinance calculator can help you estimate potential savings. 

Pros and cons of refinancing your mortgage

Refinancing a mortgage can have a lasting impact on your finances. However, it's essential to understand the potential financial commitments and costs involved.

Pros

• Lower interest rates: Reducing your rate can potentially save you thousands of dollars over the loan's life. 
• Reduced monthly payments: Refinancing into a longer loan term can make payments more affordable. 
• Faster loan payoff: Switching to a shorter loan term helps you pay off your mortgage sooner, saving on interest. 
• Cash access: A cash-out refinance allows you to use your home equity for expenses such as home improvements or debt consolidation. 

Cons

• Closing costs: Refinancing can involve additional closing costs, similar to those associated with a home purchase. These fees typically range from 2% to 5% of the loan amount. 
• Break-even period: It can take months or even years to recover refinancing costs, depending on your savings. 
• Extended loan term: If you refinance your mortgage to a longer term, you may pay more interest over time. 

How to determine if refinancing is right for you

Evaluating your current situation and future goals can help you determine whether refinancing makes sense for you. Here are a few details to consider: 

• Current interest rate: Compare your interest rate with current refinance rates from several lenders. If you can secure a significantly lower rate (such as a percentage point or more), it might be a good time to refinance. 
• Financial goals: Determine whether refinancing aligns with your short- and long-term financial goals. Will lower monthly payments, a shorter loan term or access to additional cash help you reach your goals without negatively impacting your situation?
• Potential savings: Determine how long it will take to recoup the costs of refinancing. If it takes longer to recover these costs than you plan to stay in your home, refinancing may not be the right choice. 

"You typically want to refinance for one of two reasons: You'd like to tap into your home's equity or you're looking for a lower interest rate,” says Noah Damsky, CFA, managing partner at Marina Wealth Advisors. “Compare your existing mortgage interest rate to the refinance interest rate, but ask for a no-closing-cost refinance, which rolls the closing costs into the loan balance. This shows an apples-to-apples comparison of the true monthly cost of the mortgage so you can compare your options. Maybe, on the surface, you're saving 0.25% on the refinance and it sounds like a great deal, but when you roll the closing costs into the new loan, you're actually paying more and it's easier to see because the interest rate and monthly payment increased."

Factors to consider before refinancing

Refinancing your mortgage is a major financial decision. It requires careful thought and planning. Several details can impact your ability to qualify for a new loan and determine how much you'll actually save. 

The following factors can have a significant impact on your decision and financial success: 

• Credit score: Lenders typically offer the best refinance rates to borrowers with high credit scores. 
• Debt-to-income ratio (DTI): Lenders compare your monthly debt payments to your income to predict whether you can afford monthly mortgage payments. A lower DTI increases your chances of approval. 
• Home equity: Typically, lenders require at least 20% equity in your home for a conventional mortgage refinance. Depending on the type of refinance loan you choose, you may be restricted on how much of your equity you can access. 
• Refinance costs: Factor in all of the costs involved with refinancing, like closing costs, appraisal fees, and other expenses. 
• Long-term goals: Consider whether refinancing aligns with other financial goals, such as saving for retirement or paying off debt. 

“Ask yourself if it's worth it to refinance. When interest rates drop a quarter- or half-point, borrowers rush to refinance. It sounds like a great opportunity, but they forget about closing costs,” Damsky says. “You want to minimize the number of times you refinance because closing costs are expensive.”

How to get the best rates when refinancing

Getting the best refinance rates requires planning and strategy. Lenders often reserve their best rates for homeowners with excellent credit who meet the highest underwriting requirements. A good FICO score is between 670 and 739, while an exceptional score is above 800. Even if that's not you, there are steps you can take now to improve your odds of approval and securing a low rate. 

"Compare lenders. Shop your loan with a mortgage broker that looks across many different lenders,” Damsky advises. “This ensures you're getting competitive terms. Improve your credit score by paying off other debts, paying your bills on time, and reducing the number of hard credit inquiries such as applying for other debts such as credit cards."