If you have a mortgage, you will likely consider refinancing at some point, especially when you think of your home as an investment/asset and not just a house. But how do you know if it’s the right move or if you should leave your original loan untouched?
Refinancing your mortgage means replacing your mortgage with a new mortgage that has a different (hopefully lower) interest rate, a different length, and a different loan amount. Refinancing isn’t as in-depth as buying a home with a mortgage, but the process is similar, requiring a title search, appraisal, fees, etc… As such, it can take over a month to complete.
You might consider refinancing for any number of reasons, including adding/removing one party to/from the mortgage (such as after a marriage/divorce), shortening the duration of your loan, dropping mortgage insurance, lowering your interest rate, changing from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage and using your home equity as leverage to get cash or consolidate debts. But whatever your specific reason, hopefully, your refinance will save you money.
How do I know if it’s worth it to refinance my house?
While refinancing might seem like a sure-fire way to save money, it’s not always. And if not thought out, it could end up costing you more. With fees and closing costs, refinancing can cost 2-6% of your loan amount. So you will want to take the decision seriously, think about the reason you’re refinancing, consider your future plans and determine if the savings (month to month as well as long term) is greater than the cost of the refinance. Talk to your lender and use a mortgage calculator if you need help running the numbers.
Before you can save money, you will first need to break even on the money you spent on closing costs on the refinance. The breaking-even period is the time it takes you to recoup those costs and start actually seeing the savings. If it takes too long to recoup that money or if you plan on moving soon, it may not be worth refinancing. To give you an idea of your breaking-even period, you can divide your closing costs by your monthly savings. You can estimate your monthly savings based on your new interest rate, or you can reach out to the lender for an estimate. For example, if your closing costs are $3,500 and your estimated monthly savings come to $40, then 3,500 ÷ 40 = 87.5. That means you will break even in 87 ½ months or 7.29 years, so you will not see savings until then. If you plan on moving before that time, then refinancing would most likely not make sense, because you will not recoup the money in time to see any savings.
But even if you’re planning on moving or refinancing again before you break even, it could still make sense to refinance if you have a no-cost refinance or if you roll the closing costs into the new loan. A no-cost refinance is when you pay a higher interest rate in return for your lender paying some or all of your closing costs. Rolling closing costs into the cost of your loan is exactly how it sounds–making the closing costs part of your loan amount. This will increase your principal and your interest due, but it’s possible it could save you money in the long run. For people who plan on keeping the loan for several years, rolling the closing costs into the loan may be the more cost-effective option of the two. But again, do the math and determine if you will save money with either of these options.
Common Reasons to Refinance:
Lowering your interest rate
The most common reason to refinance is to lower the interest rate. By refinancing when interest rates are lower than your current rate, you can reduce your monthly payments, save on the total amount of interest due and even pay off your loan sooner. You might recall during the pandemic when interest rates dropped to historical lows (from 3.7% in January 2020 to 2.65% in January 2021), many people took advantage of those new rates, which were surely lower than the interest rates on their original loans.
But when refinancing, how much should your interest rate drop? Many experts recommend refinancing if you can lower your interest rate by 1% or more. Some even say 2%. But even a 1% drop would likely result in considerable savings (hundreds of dollars a month) which can be saved, invested, used on expenses or even put toward paying off your loan early. Paying off your loan early could give you additional savings by reducing the total interest due and help you build equity faster.
But that’s not to say that you can’t also save money with a smaller rate drop than 1%, such as if you stay in the home long enough to break even and/or you do a no-cost refinance. The more your interest rates drop, the more you will save each month. Conversely, with a smaller drop, you will save less each month and it will take you longer to break even.
Shortening the length of your loan
The longer your loan, the more interest you will pay, because your lender is collecting interest over a longer period of time. So shorter loans will have less interest due even if you can’t get a lower interest rate. But shorter loans can cause higher monthly payments. Once again, you will want to calculate the savings and the cost short-term and long-term to determine if it’s a wise financial move.
Converting from an adjustable-rate mortgage to a fixed-rate mortgage
You may want to refinance to convert from an adjustable-rate mortgage to a fixed-rate mortgage. ARMs have interest rates that may start out lower but change over time based on the current market. That can be good when rates are low, but it can also mean very high rates and uncertainty. Refinancing will allow you to switch to a mortgage with a fixed rate that will not change or fluctuate based on the market. But if you already have a low-interest fixed-rate mortgage, your new rate would need to be considerably lower for you to see savings after you factor in closing costs. So you may choose to switch from a fixed-rate mortgage to an adjustable-rate mortgage if the ARM has a better current rate.
ARMs tend to have lower monthly payments and could be beneficial when interest rates are dropping or for people who plan to move out of their homes within a few years. But this may not be the wisest decision for most people, as ARMs are much riskier since you don't know what the rate will be in the future. If you get an ARM when rates are low, chances are they won’t go any lower and will ultimately go up, meaning you’ll have to pay more interest. So as enticing as it may be to refinance with that lower rate, this option could end up costing you more once the rate resets and increases.
Leveraging your equity
Your home and the equity you have in it is an asset you can use. With your home equity as collateral, you can take out a home equity loan, a home equity line of credit (HELOC), reverse mortgage, or cash-out refinance. Each option will give you access to cash if you need it. Some homeowners leverage their equity to fund a renovation, pay a down payment on another home or pay another large expense. But some choose to consolidate their debt, which means combining multiple different debts into one single loan with one monthly payment.
Regardless, tapping your equity is a big decision that comes with risk, because you lose equity, you increase your debt, and it’s possible your home’s value could decrease. If it decreases with a home equity loan or HELOC, you could end up underwater on your loan, so you would owe your lender more than the value of the home. And debt consolidation can be dangerous in and of itself because you are using your home as collateral for other loans. So if you fail to make your payments, you can lose your home. And if you sell a home that is cross-collateralized, the remaining property will have to support your debt.
Is refinancing a smart money move?
No one can answer this question without knowing your finances. Generally speaking, if you’re saving money, it’s probably worth it. But if you refinance without saving or if you can’t afford the closing costs, then it probably would be a waste. Refinancing has drawbacks to be sure, so just because you can do it doesn't necessarily mean you should. Closing costs (2-6% of the loan) can be considerable. Plus, when you refinance, your old loan disappears and you restart on day one of a new loan for another 15 or 30 years. With a longer loan, you could actually end up paying more interest if your new interest rate isn’t significantly lower than your original one.
Weigh everything. It may not be worth it if your credit score is low, because you won’t be eligible for a low-interest rate; if you’re far into your original loan or almost done paying it off, since you won’t likely get enough savings to offset the cost; or if you already have a low-interest rate (such as if you bought a home during the pandemic), because chances are, you won’t get a lower interest rate or at least not one low enough to outweigh the closing costs.
The Bottom Line
Refinancing can be beneficial if it lowers your costs, allows you to build equity faster, or shortens the length of your loan. But don’t just look at the interest rate and assume a new loan will save you money. Factor in the closing costs and examine how a refinance will affect your finances in the short term and in the long term. If the refinance will cost more than your current loan or leave you unable to afford your monthly payment, you may want to reconsider. But if your situation is such that the savings are greater than the cost to refinance and you can afford the monthly payments, you could end up saving yourself thousands of dollars over the life of the loan.