When Should You Refinance Your Mortgage?

When Should You Refinance Your Home?

Before applying for a mortgage refinance, take some time to consider why you want to refinance and how it would help you accomplish your goals. Here are five common reasons homeowners refinance their mortgages:

To Get a Lower Interest Rate

If your credit has improved or mortgage rates have dropped since you took out your existing loan, you may qualify for a lower rate and monthly payment. As a result, you could save tens of thousands of dollars over the life of the loan with a rate-and-term refinance.

To Change Your Loan Term

Since lenders typically offer lower mortgage rates for shorter-term mortgages than longer-term ones, you may be able to reduce your mortgage rate by shortening your loan term. If you have a 30-year mortgage, research the current rates for 15- and 20-year mortgages at your lender and other competitors to see if you could lower your mortgage rate.

Switching to a shorter-term loan typically results in interest savings over time, but could cause your monthly payment to increase. Conversely, switching from a shorter-term loan to a longer one could be an option if you're looking for lower monthly payments, although it may result in higher total interest costs over time.

To Change Your Loan Type

Consider switching to a fixed-rate mortgage if you want to eliminate the rate fluctuations that come with an adjustable-rate mortgage (ARM). ARMs typically come with lower initial interest rates for the first few years but then adjust—usually upwards—at regular intervals. Refinancing from an ARM to a fixed-rate mortgage will result in fixed payments and a more predictable and manageable home loan.

To Get Cash

A cash-out refinance allows you to access some of your home equity. In this case, you replace your original loan with a larger one and receive the difference as cash. You can then use the funds to consolidate high-interest debt, fund a home improvement project or address another financial need.

To Add or Remove a Borrower

Refinancing is necessary if you want to add or remove a borrower from your mortgage, as it changes the loan's terms. Make sure anyone you want to add to the mortgage has stable income and strong credit to ensure the interest rate you receive is on par with your current rate. Removing someone from the mortgage can be challenging because the remaining borrower(s) must be able to qualify for the new home loan without the co-borrower.

When Shouldn't You Refinance Your Home?

Refinancing is an excellent option in many cases, but it isn't ideal for everyone. Here are some scenarios when you should think twice before refinancing:

You Can't Get a Lower Interest Rate

Mortgage refinancing makes little sense if your new loan comes with a higher interest rate and, consequently, higher monthly payments. Not only would it add to your monthly budget, but you'd pay more in total interest charges. As a general rule, you shouldn't refinance unless you can secure an interest rate at least 1% lower than your existing mortgage rate.

Even if the new loan comes with interest rates near your current rate, closing costs could negate any potential benefit. Depending on your closing costs, it may take up to 10 years to break even on a new mortgage that is only 0.50% lower than your current one.

You Just Bought Your Home

When you refinance your mortgage, any savings you receive from a lower interest rate could be offset by closing costs ranging from 2% to 6% of the loan amount. It may not be worth refinancing if you don't plan on living in the home long enough to recoup these costs in interest savings.

You Plan to Use the Cash Difference for Nonessential Spending

Using a cash-out refinance to pay for a luxury vacation, sports boat or other nonessential spending is probably not a good idea. Don't forget, your home serves as collateral when you refinance, which means your lender can foreclose if you default on the loan. Using refinance funds to improve your financial position—such as consolidating high-interest credit cards or investing in home improvement projects—is a better use for the funds.

How Much Does a Mortgage Refinance Cost?

When refinancing your mortgage, your lender will likely charge you closing costs ranging from 2% to 6% of the loan amount. So, if you're refinancing a $400,000 loan, closing costs could run you $8,000 to $24,000. If the new loan lowers your monthly payment by $200 and you live in the home for at least five years, you might save $12,000 over the period. In this scenario, you'd save money if your closing costs were less than $12,000 but would need a longer time horizon to come out ahead if your closing costs were higher.

Closing costs cover a broad range of expenses, from origination and home appraisal fees to title services and attorney fees. Freddie Mac advises loan applicants to understand that any lender offering "no-cost refinance" mortgages is likely charging a higher mortgage rate and wrapping closing costs into the loan.

Is It a Good Idea to Refinance Your House?

Deciding whether or not to refinance depends on your unique financial situation, loan offer, how long you plan on living in the home and other factors. Refinancing your house is generally a good idea if you achieve one of the goals outlined above, including getting a lower interest rate, changing your loan term to suit your financial goals or accessing cash.

Take the time to determine your costs or savings to see if refinancing is worth it. When you lay it all out, you may ultimately find that a refinance isn't justified.

How to Refinance Your Mortgage

If you decide to refinance your mortgage, follow these steps:

1. Review your credit. Before applying, check your credit report and credit score to determine if they're strong enough to qualify for a new home loan. You'll typically need a credit score of 620 or higher; borrowers with higher credit scores tend to secure lower interest rates. If your credit score is lower than you'd like, take steps to improve it to potentially qualify for a lower rate.
2. Evaluate your equity. Generally, you'll need 20% home equity to qualify for a mortgage refinance. Put another way, the loan-to-value ratio (LTV)—a percentage representing the amount of your home loan compared to the home's appraised value—should be 80% or less. However, requirements vary from lender to lender, so it's important to compare different lenders to find the best fit for your needs. To calculate your home equity, subtract your current mortgage balance from your home's market value. For example, if your home's current value is $400,000 and your remaining loan balance is $300,000, you have $100,000 in home equity, or 25%.
3. Shop and compare loan rates and fees. The Consumer Financial Protection Bureau (CFPB) recommends getting three or more loan estimates when shopping for a mortgage loan. Reviewing several loan offers allows you to compare interest rates, repayment terms, fees and other benefits to find the best overall mortgage refinance loan.
4. Do your due diligence. Compare the savings and costs of any loan you're considering to make sure it makes financial sense. For instance, if the loan would lower your payment by $200, but the closing costs are $10,000, it would take 50 months to break even. Refinancing may save you money if you plan on living in the home longer than that.
5. Submit your application. Once you've chosen a loan offer, fill out an application on your lender's website or over the phone if you want a loan officer to walk you through the sections. Depending on your lender, you may be able to apply in a local office. Gathering your proof of income, tax records, bank statements and other supporting documents beforehand can help the application process run more smoothly.
6. Close the loan. Typically, you'll need to meet with your lender to finalize the closing, pay closing costs and fees and sign documents. Consult with your lender about closing payments on your existing loan so there are no missed payments that could damage your credit. You should receive a letter or email from your new lender detailing your new monthly due date, amount and payment instructions.

The Bottom Line

It's always wise to know where your credit stands, especially if you decide to refinance your mortgage. After all, lenders base your loan approval and interest rate, in part, on your creditworthiness.

Start by accessing your credit report and credit score for free with Experian. Review your report for any errors or discrepancies and, if necessary, implement strategies to improve your credit score.