With mortgage rates still at lows, it can make sense to refinance your loan. Here’s what you need to know about the process, and when it’s a good idea.
What is mortgage refinancing?
Refinancing a mortgage means you get a new home loan to replace your existing one, with the option to withdraw a portion of your home’s equity out as cash in the process. If you can refinance into a loan that has a lower interest rate than you’re currently paying, you could save money on your monthly payment and interest you pay over the term of the loan.
When it makes sense to consider mortgage refinancing
The best time to consider a mortgage refinance is when interest rates sink below the level they were when you closed on your original loan. As a rule of thumb, it’s worth considering a refinance if you can lower your interest rate by at least half a percentage point, and you’re planning to stay in your home for at least a few years.
Another good opportunity is when your credit improves to the point where you qualify for a new loan that has a lower interest rate.
There are a variety of reasons to refinance that can make financial sense, including:
- To reduce your monthly mortgage payment by securing a lower interest rate
- When the costs of refinancing can be recouped in a reasonable time period
- To get a shorter term, such as a 15-year loan to replace a 30-year mortgage, so you can pay it off faster and pay a lot less in total interest
- To switch from an adjustable-rate mortgage (ARM) to a fixed-rate loan — a smart move if you think rates are going to go up in the future
- To extract cash from your home’s equity in a cash-out refinance
- To eliminate mortgage insurance if you’ve built up 20 percent equity in your home
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The refinance clock is ticking
Mortgage rates fell to all-time lows in late 2020 and early 2021, but began edging up in February. While they still remain relatively low, mortgage experts expect rates to rise as the coronavirus vaccine is distributed and the U.S. economy returns to normal.
Mortgage rates probably won’t soar, however — the Federal Reserve has vowed to keep the rate it controls near-zero until further notice. The Fed doesn’t directly control mortgage rates, but its decisions do influence the mortgage market.
If mortgage rates do in fact follow the experts’ consensus, they’ll probably end up in the range of 3.5 percent by the end of 2021. In other words, the window to refinance is gradually tightening rather than slamming shut.
How to refinance your mortgage
Step 1: Set a clear financial goal
There should be a good reason why you’re refinancing, whether it’s to reduce your monthly payment, shorten the term of your loan or pull out equity for home repairs or debt repayment.
“Every situation is unique,” says Ann Thompson, Bank of America’s head of retail sales West. “Everyone has different priorities.”
What to consider: If you’re reducing your interest rate but restarting the clock on a 30-year mortgage, you may end up paying less every month, but more over the life of your loan. That’s because the bulk of your interest charges are in the early years of a mortgage.
Step 2: Check your credit score and history
You’ll need to qualify for a refinance just as you needed to get approval for your original home loan. The higher your credit score, the better refinance rates lenders will offer you — and the better your chances of underwriters approving your loan.
What to consider: Lenders became stricter about extending credit due to the uncertainty of the pandemic, so the typical mortgage borrower’s credit score is higher now than it has been in previous years. While there are ways to refinance your mortgage with bad credit, it can make sense to spend a few months boosting your credit score before you start the process.
Step 3: Determine how much home equity you have
Your home equity is the value of your home in excess of what you owe your mortgage lender on your loan. To figure it out, check your mortgage statement to see your current balance. Then, check online home search sites or get a real estate agent to run an analysis to find the current estimated value of your home. Your home equity is the difference between the two. For example, if you still owe $250,000 on your home, and it is worth $325,000, your home equity is $75,000.
What to consider: You may be able to refinance a conventional loan with as little as 5 percent equity, but you’ll get better rates and fewer fees (and won’t have to pay for private mortgage insurance, or PMI) if you have more than 20 percent equity. The more equity you have in your home, the less risky the loan is to the lender.
Step 4: Shop multiple mortgage lenders
Getting quotes from multiple mortgage lenders can save you thousands. Once you’ve chosen a lender, discuss when it’s best to lock in your rate so you won’t have to worry about rates climbing before your loan closes.
What to consider: In addition to comparing interest rates, pay attention to the cost of fees and whether they’ll be due upfront or rolled into your new mortgage. Lenders sometimes offer no-closing-cost refinances but charge a higher interest rate or add to the loan balance to compensate.
Step 5: Be transparent about your finances
Gather recent pay stubs, federal tax returns, bank statements and anything else your mortgage lender requests. Your lender will also look at your credit and net worth, so disclose your assets and liabilities upfront.
What to consider: Having your documentation ready before starting the refinancing process can make it go more smoothly.
Step 6: Prepare for the appraisal
Mortgage lenders typically require a mortgage refinance appraisal to determine your home’s current market value.
What to consider: You’ll pay a few hundred dollars for the appraisal. Letting the lender know of any improvements or repairs you’ve made since purchasing your home could lead to a higher appraisal.
Step 7: Come to the closing with cash, if needed
The closing disclosure, as well as the loan estimate, will list how much money you need to pay out of pocket to close the mortgage.
What to consider: You might be able to finance those costs, which typically amount to a few thousand dollars, but you’ll likely pay more for it through a higher rate or loan amount. In most cases, it makes more financial sense to pay the costs upfront.
Step 8: Keep tabs on your loan
Store copies of your closing paperwork in a safe location and set up auto-payments to make sure you stay current on your mortgage. Some banks will also give you a lower rate if you sign up for auto-payment.
What to consider: Your lender might resell your loan on the secondary market either immediately after closing or years later. That means you’ll owe mortgage payments to a different company, so keep an eye out for mail notifying you of any such changes.
Benefits of refinancing your mortgage
Free up money each month
A rate-and-term refinance replaces your mortgage with a new loan that has a lower rate, meaning you have to pay less to your lender each month.
“There’s a significant opportunity to reduce your monthly cash requirements,” says Glenn Brunker, president of Ally Home. “Depending on the size of your mortgage, it could be $75 or $100 per month, or even several hundred dollars a month.”
Pay your home off faster
You could refinance into a loan with a lower interest rate and a shorter term. The savings in interest payments could be substantial, for example, if you’re able to refinance into a 15-year mortgage from a 30-year loan. Still, if you’re putting more cash into paying off your mortgage, you could have less money on hand for expenses like saving for retirement, college or an emergency fund.
If your original down payment was less than 20 percent, you have likely been paying private mortgage insurance, or PMI, an extra fee on every payment. If rising home values and your loan payments have pushed your home equity above 20 percent, you might be able to refinance into a new loan without PMI.
Tap your home’s equity
Homeowners with well over 20 percent equity in their home sometimes turn to cash-out refinancing. That’s when you refinance your home loan into a new mortgage for a larger amount to meet a specific financial need and receive the difference in cash. This can make sense if you’re considering using the money to invest back into your home through a major remodeling project or to pay off high-interest debt.
Lock in a fixed-rate mortgage
If you’re in an adjustable-rate mortgage (ARM) that’s about to reset and you believe that interest rates are going to rise, you can refinance into a fixed-rate loan. Your new rate might be higher than what you’re paying now, but you’re guaranteed it won’t rise in the future.
Risks of refinancing your mortgage
Refinancing isn’t free
Your refinanced mortgage comes with costs, such as an origination fee, an appraisal, title insurance, taxes and other fees, just like your original mortgage. Even if the refi results in a lower monthly payment, you won’t actually save money until the monthly savings offset the cost of refinancing. You’ll need to do some math (use this calculator) to figure out how many months it will take to reach this break-even point. If there’s a chance you’re going to move before then, refinancing is probably not the best move.
You might have a prepayment penalty
Some mortgage lenders charge you extra for paying off your loan amount early. A high prepayment penalty could tip the balance in favor of sticking with your original mortgage.
Your total financing costs can increase
If you refinance to a new 30-year mortgage and you’re well into paying off your initial 30-year loan, you’re going to pay more in interest than if you’d kept the original mortgage, since you’re extending the loan repayment time.
Refinance vs. cash-out refinance: What’s the difference?
When you refinance in order to reset your interest rate or term, or to switch, say, from an ARM to a fixed-rate mortgage, that’s called a no cash-out refinance, or a rate-and-term refinance. Rate-and-term refinancing pays off one loan with the proceeds from the new loan, using the same property as collateral. This type of loan allows you to take advantage of lower interest rates or shorten the term of your mortgage to build equity more quickly.
By contrast, cash-out refinancing leaves you with more cash than you need to pay off your existing mortgage, closing costs, points and any mortgage liens. You can use the cash for any purpose. To be eligible for cash-out refinancing, you typically need to have substantially more than 20 percent equity in your home.
Example of a no cash-out refinance (rate-and-term refinance)
Jessica gets a $100,000 mortgage with an interest rate of 5.5 percent. Three years later, interest rates have fallen, and Jessica can refinance with an interest rate of 4 percent. After 36 on-time payments, she still owes about $95,700.
In this situation, Jessica can save more than $100 per month by refinancing and starting over with a 30-year loan. Or she can save $85 per month, while keeping the loan’s original payoff date, paying it off in 27 years, and also reducing the total cost of the loan by about $8,000.
Better still in terms of saving on interest would be to refi into a 15-year loan. The monthly payments will be higher, but the interest savings is massive.
Example of a cash-out refinance
Christopher and Andre owe $120,000 on a mortgage on a home that’s worth $200,000. That means that they have 40 percent, or $80,000, in equity. With a cash-out refinance, they could refinance for more than the $120,000 they owe. For example, they could refinance for $150,000. With that, they could pay off the $120,000 on the current loan and have $30,000 cash to pay for home improvement and other expenses. That would leave them with $50,000, or 25 percent equity.
Next steps: How to get the best refinance rate
Once you’ve determined why you want to refinance and the type of loan you want, you’re ready to shop lenders and compare refinance rates. Get quotes from at least three mortgage lenders, including a mortgage broker, a bank and an online lender. Be sure to compare their rates as well as fees and other charges that could add to the overall cost of the loan.