When to refinance your mortgage

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The average household in the U.S. spends $1,279 per month on mortgage payments, according to statistics from bill payment service doxo. Like many homeowners, this likely makes up the largest expense on your list of financial responsibilities. If that recurring bill is a source of stress, there’s good news: You might be able to make it smaller if you consider an important question: Should I refinance my mortgage?

Should I refinance my mortgage?

The headlines about record-low mortgage rates might lead you to believe refinancing is the right move for you — and it could be.

Consider these numbers: The average 30-year fixed mortgage rate was 3.86 percent at the beginning of 2020, according to Bankrate data, but by the end of the year, had plummeted to 2.96 percent. In 2021, rates have continued to hover near that 3 percent-mark for borrowers with strong credit.

However, the math isn’t as simple as comparing the rate you locked in when you were approved for your mortgage versus the rate you can qualify for now. Take into account these three factors, recommends Bill Packer, executive vice president and chief operating officer of mortgage lender American Financial Resources:

“1.) The after-tax monthly savings (new payment compared to old payment after any tax-favored treatment); 2.) the amount of time that I intend to be in the home; and 3.) the cost to obtain the new mortgage. Once you know these three things, you can then calculate your return and see if it is positive.”

In addition, ask yourself these questions.

When it’s a good idea to refinance your mortgage

Generally, if refinancing will save you money, help you build equity and pay off your mortgage faster, it’s a good decision.

Even borrowers who have fairly new mortgages might be able to benefit from refinancing. Say you were approved for your mortgage at the start of 2020. Although you’re less than two years into your loan, the ability to now lower your interest rate by one-half to three-quarters of a percentage point can substantially lower your monthly payment and reduce the interest over the life of the loan.

So, when is it a bad idea to refinance? For the above example, it might not be smart to refinance if you plan to move in the next two years, which gives you little time to recoup the cost.

The question of when to refinance is not just about interest rates or your timeline, either; it’s about your credit being good enough to qualify for the right refinance loan. The best rates and terms go to those with the best credit, so check your credit report to have a solid understanding of your risk profile. If you’re carrying a high credit card balance or you’ve missed a payment recently, you might look like a riskier borrower.

How long does it take to recoup the costs of refinancing?

The interest rate is not the only cost to weigh when you’re considering whether refinancing is worth it. There are costs to close the new loan, and they can be steep. Expect closing costs to total 2 percent to 5 percent of the principal amount of the loan. If you borrow $250,000 and closing costs are 4 percent, for example, you would owe $10,000 at closing.

Rather than require all that money upfront, many lenders let you roll the closing costs into your principal balance and finance them as part of the loan. Keep in mind, though, that adding those costs to the loan only increases the total amount that will accrue interest, ultimately costing you more.

How to calculate the break-even point

“The break-even point on a mortgage refinance occurs when savings equals costs,” explains Jared Maxwell, vice president of consumer direct lending at Embrace Home Loans.

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

Let’s say that refinancing will save you $150 per month, and the closing costs on the new loan are $4,000:

$4,000/$150 = 26.6 months

So, if you were to close your new loan today, you’d officially break even just over two years and two months from now. If you live in the home for an additional five years after that point, the savings really start to add up — $9,000 total.

You can use Bankrate’s refinance break-even calculator to figure out how long it will take for the cost of a mortgage refinance to pay for itself. If you think you might sell the home before your break-even point, refinancing might not be worth it.

Example of a mortgage refinance

Let’s say you took out a 30-year mortgage for $200,000 at a fixed interest rate of 4.75 percent. Your monthly payment is $1,043. Over the life of the loan, you’d pay $375,586.08, which includes more than $175,586 in interest.

Three years into the loan, you’ve paid $10,006 toward the principal and $28,596 in interest. Now you want to refinance the remaining $189,994 of your principal balance with a new 30-year fixed-rate loan at 3.5 percent.

Your new loan would slash your monthly mortgage payment to $853 per month, giving you an additional $190 of wiggle room in your monthly budget. Over the life of the loan, you’d pay $307,136, of which $117,142 would be interest. Add in the $38,602 in principal and interest you paid in three years on the previous mortgage, and your total cost will be $345,738.

By refinancing, you’d not only lower your monthly payments significantly — you’d see a long-term savings of nearly $30,000, less closing costs, compared with your original loan.

How long does it take to refinance a mortgage?

Refinancing a mortgage doesn’t happen overnight. The same work involved in your first mortgage — verifying your income and reviewing your credit and debt, appraising the property, underwriting and closing — applies here, too. The average refinance took 47 days to close, or about a month and a half, as of July 2021, according to ICE Mortgage Technology.

Some lenders complete closings faster thanks to automated online processes. When shopping around for refinance options, ask each lender about their average closing times and the estimated closing costs you’d need to pay.

Don’t let the process intimidate you, either. A recent Bankrate survey shows that homeowners who haven’t refinanced in today’s low-rate environment cited “too much paperwork” as one of their reasons for avoiding it. Taking care of that paperwork now can save you more valuable paper (dollar bills) down the road.

Is refinancing worth it?

If it frees up money in your monthly budget or reduces the overall cost of the loan, refinancing is well worth the work and money.

There’s no one correct path to do it, however — there are a variety of ways to refinance your mortgage. You might want to switch from an adjustable-rate mortgage to a fixed-rate loan that has a steady monthly payment, or you might want to shorten the term of your loan from a 30-year to a 15-year and save yourself a bundle in interest charges. You could also simply move from one 30-year mortgage to another 30-year mortgage with a lower rate.

Additionally, refinancing presents a way to get rid of private mortgage insurance (PMI) after you have accumulated 20 percent equity in your home.

Many homeowners opt for a straight rate-and-term refinance that lowers their interest rate and gives them a comfortable repayment term. Some want a lower monthly payment to free up money for other expenses, such as college tuition or an auto loan.

While rate-and-term options should help you save money, a cash-out refinance can help you borrow more of it. With this approach, you’re able to take additional cash out with the new loan that can go toward other financial moves, such as paying off credit card debt (since that has a higher APR, you’ll be reducing the cost of the debt) or for a big home remodeling project.

There are pros and cons for cash-out refinances, so you’ll need to think carefully about what you plan to do with the money to figure out whether you should increase the size of your home loan. By taking on more debt, you’re ultimately making paying off your mortgage more challenging, and likely more expensive.

Video: When to refinance your mortgage

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Written by
David McMillin
Contributing writer
David McMillin writes about credit cards, mortgages, banking, taxes and travel. David's goal is to help readers figure out how to save more and stress less.
Edited by
Mortgage editor
Reviewed by
Professor of finance, Creighton University
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