Updated Oct 25, 2022
Refinancing your home is a big decision, especially because mortgage loans aren’t one-size-fits-all. Before diving into a new loan plan, it’s important to consider a few personal factors.
We’ll discuss these factors and more to help you decide if refinancing is right for you. By the time you finish reading, you’ll have a clearer understanding of how refinancing could help you afford monthly payments or why it might not be the best choice for your financial health.
A mortgage is a loan you take out to pay off a real estate investment over time. Your mortgage will come with a fixed term, the amount of time you have to pay off the loan and build equity in your property. A 15-year mortgage will require higher monthly payments to pay off in a shorter period. Meanwhile, a 30-year mortgage will have lower monthly payment requirements but take longer to pay off.
Your mortgage consists of monthly interest and principal payments:
Principal payments —This is the actual loan amount you borrowed. It goes toward paying off your mortgage and building your equity in the home.
Monthly interest —This is the percentage of your monthly payment that goes toward paying the lender to borrow. Although this portion of your monthly mortgage expense doesn’t help you pay off the house, it makes the loan worthwhile for the lending institution. The longer you pay off your mortgage, the smaller the interest becomes, meaning more of your monthly payment goes toward paying off your home loan as time goes on.
Refinancing a home means taking out a new mortgage to replace an old one. Most homeowners refinance their homes hoping the new loan will have better terms than their current mortgage, allowing them to pay less each month or pay off the loan sooner.
Despite these apparent benefits, mortgage refinancing isn’t the best option for every homeowner. In some cases, the price of a refinance loan — closing costs, applications, new appraisal fees, and other homebuying costs — negate the benefits of refinancing. Before applying to refinance, calculate your break-even point to determine if a new loan is financially practical.
The break-even point is the number of months it takes to see the financial benefit of your refinance. You can calculate it by dividing the total costs of your new loan by the savings you’d gain each month. For example, if it costs you $5,000 to refinance your home but you’d save $250 monthly on your mortgage, you’d break even in 20 months.
There’s no clear-cut rule for how quickly you should break even when refinancing your mortgage. However, it’s generally best to ensure your break-even point is less than the number of years you plan to live in the home. For example, if you plan to stay in your current home for three years but calculate your break-even point to 40 months, you won’t see the savings from your lower interest rates. On the other hand, it’s fine to have a longer break-even period if you’ve found your forever home. You may not see the savings from your refinance for a while, but the new loan will be worth it in the long run.
Knowing the pros and cons of refinancing before taking out a new loan is crucial to your financial success. Here are some benefits and drawbacks to consider before tossing your old mortgage to the curb.
Not every homeowner is eligible for a new mortgage loan. The following sections cover a few requirements lenders look for when considering a mortgage refinance application.
Before handing over any money, a mortgage lender will assess your credit score to see if you’re a trustworthy borrower. Your credit score shows the lender how likely you are to repay a loan based on your credit card history, repayment trends, and your number of open loan accounts.
Depending on the type of lender, you’ll need a credit score of at least 620 to qualify for a new mortgage. If you have an exceptional credit score (above 800), you’ll likely qualify for lower interest rates and better loan terms.
Most mortgage lenders require borrowers to have substantial home equity before refinancing their homes. Equity is the portion of your home that you own. For example, if you bought a home for $300,000 and put down a $30,000 down payment at closing, you’d have 10% equity. Most lenders prefer homeowners to have at least 20% home equity before qualifying to refinance.
If you try to take out a new loan without enough home equity, the lender will require you to purchase private mortgage insurance (PMI), which will add premiums to your monthly mortgage costs.
A lending institution will also assess your debt-to-income ratio (DTI) before refinancing your home. Your debt-to-income ratio compares your monthly debt payment obligations to your gross monthly income. This percentage helps lenders determine whether you can realistically afford a new loan on top of your existing financial obligations.
You’ll typically need a DTI below 43% to qualify for a new loan. Find your DTI by dividing the total of your monthly debt payments by the amount you make each month before taxes.
Once you’ve determined that you qualify for refinancing, it’s time to see if a new loan would benefit your financial goals. Below, we’ll explain several situations in which refinancing is a good idea. While reading, consider whether refinancing could be a long-term solution to your home payment plan.
Refinancing may be a good option if your credit score has vastly improved since your original loan started. The higher your credit score is, the more likely a lender will approve your mortgage application. The lender may also be more willing to offer favorable terms and more affordable interest rates for your mortgage loan.
Lower interest rates are a massive incentive for refinancing. Even dropping your mortgage’s interest rate by 1% could save you tens of thousands of dollars across the life of your loan.
If your improved credit score has increased the possibility of better loan terms, you should shop around with multiple lenders to find the best interest rate. Different lending institutions will provide different quotes based on your application. A 2021 Freddie Mac report says that comparing as few as four quotes can save you approximately $3,000 on your loan. Some lenders may even be willing to match interest rates if you show them a quote from a competitor with better terms.
Mortgage interest rates are determined by more than just your credit score and the lender you choose. Factors like the Federal Reserve and inflation rates also affect mortgage interest. If current rates are better than those of your original mortgage, you could score some significant monthly savings by refinancing.
Perhaps you’ve been paying off a 30-year loan for a few years and would like to speed up the process. In this case, refinancing could be an opportunity to shift from a longer-term mortgage plan to a shorter-term option. With a shorter-term plan, such as a 15-year loan, your monthly payments will be higher, but you’ll likely score lower interest rates. Plus, you’ll pay off your mortgage sooner, which increases the number of debt-free years you’ll enjoy in your home. Once your mortgage is paid off, you can use those savings to pay off other loans, put money towards retirement savings, etc.
Let’s say you’ve been paying off your mortgage on a 15-year term. Despite more favorable interest rates, surging monthly expenses have turned your mortgage into an unaffordable monthly expense. In this instance, you might refinance your home to trade your current loan for one with a longer term. You’ll pay more total interest over time, and your loan will take twice as long to pay off. However, you’ll have peace of mind knowing your monthly payments are more feasible for your budget.
You may want to refinance your home to change your loan from an adjustable-rate mortgage to a fixed-rate mortgage or vice versa.
A fixed-rate loan has a consistent interest rate throughout the loan’s life. This means your monthly mortgage payments will be predictable and steady, regardless of whether current interest rates rise or fall. The downfall of fixed-rate mortgages is that they often have higher interest rates than the alternative. However, the rate stays consistent regardless of institutional fluctuations, allowing you to budget for the same amount each month.
An adjustable-rate mortgage (ARM) has interest rates that fluctuate across the life of the loan. ARMs typically have lower interest rates upfront, which is why many people apply for them instead of fixed-rate loans. However, this type of mortgage typically develops higher interest rates as the term progresses. For this reason, ARMs are generally a better option for short-term homeowners. If you bought your forever home with an ARM and start to notice rates increasing, it might be time to lock in a fixed-rate refinance loan.
Refinancing could be a good option if you need to free up cash to pay for home improvement projects or other high-interest debts. You can do this by using a type of loan called a cash-out refinance or cash-out refi.
A cash-out refi takes out a new mortgage to repay your existing loan. You pocket the difference between the two amounts and can use it for large expenses. These loans are popular among homeowners who need extra cash for expensive home improvements because the money goes back into the home to increase its value even more.
Cash-out refinancing isn’t a good option for everyone. For example, it might be a mistake if refinance rates are much higher than the ones you currently pay. In this case, you might lose money in the long run despite getting a large upfront payout.
Cash-out refinancing is probably the best choice for those whose home values have increased substantially since the first mortgage began. In this case, the homeowner will get a new appraisal to confirm the increased value and a higher loan to match.
Whether refinancing is worth it for you depends on several factors. Before applying for a new loan, you should first assess the following:
The bottom line is that your mortgage and financial health are unique to you. If these factors line up, refinancing could be an excellent opportunity to lock in better mortgage rates and more favorable loan terms. Otherwise, staying put in your existing mortgage could be the safer option.