Your home is likely one of your most highly valued assets. And your mortgage is probably one of your largest monthly expenses.
Like with most areas of your financial plan, you want to make sure you’re maximizing your savings and minimizing costs associated with your mortgage — all while balancing your life today with goals for the future.
So, as mortgage rates hover at near-historic lows, you may be considering refinancing.
When done effectively, refinancing can put more money in your pocket. It can reduce your monthly payment, give you access to cash from your home’s equity, improve your loan terms, or help you consolidate debt.
But how do you know if refinancing is right for you? Here are some of the most important factors:
- The break-even point. Refinancing isn’t cheap. Depending on your situation, it could cost anywhere between 3% to 6% of the remaining principal on your mortgage. So, it’s important to make sure that the upfront costs of refinancing (like, closing costs and your time) are offset by the long-term savings. If you plan to sell your home before the break-even point, then it likely won’t make sense to refinance.
- Current and projected interest rates. You want to refinance when interest rates are low. If you’re considering refinancing, you want to make sure you don’t wait too long — especially if interest rates are expected to increase soon (as is the case in 2022).
- Your current mortgage payoff schedule. If you’re within 2-3 years of paying off your mortgage, it’s unlikely you’ll stand to gain any meaningful benefit from refinancing. At this stage, only a small portion of your payments are going toward interest.
- Your current mortgage terms. Depending on your situation, it may be beneficial for you to convert an adjustable-rate mortgage (ARM) into a fixed-rate mortgage, or vice versa. If you are considering refinancing, you’ll also want to know if your current mortgage terms include any prepayment penalties.
- Your credit history. If your credit history has improved significantly since you applied for your current mortgage, it’s likely that you would qualify for a better interest rate and more favorable mortgage terms.
- Your cash needs and home’s equity. If you’ve built equity in your home and have cash needs — whether to fund education or cover a major expense — a cash-out refinance may be a good option. Beyond a cash-out refinance, if you have immediate cash flow needs, some refinancing options may reduce your monthly payment. You’ll need to make sure you have more than 20% equity in your home — a common requirement to qualify for refinancing.
- Your debt and savings goals. If you have any high-interest debt like credit cards or student loans, a cash-out refinance can help you pay off that debt and consolidate it into a mortgage with a much lower interest rate. Refinancing may also free up some additional funds that can be redirected to other savings goals, like maximizing your retirement savings.
Refinancing takes time and effort. And it isn’t free. Before diving too far into the process, here are some things you should know.
What does refinancing a mortgage mean?
When you refinance, you take out a new mortgage to pay off your existing mortgage. This is done in essentially the same way as your initial mortgage.
There’s not much you need to worry about when it comes to paying off your existing mortgage. In most cases, the lender for your new (or refinanced) mortgage will pay off your existing mortgage directly.
So, think of it as getting rid of your old (or current) mortgage so that you can get a new one.
What are the main reasons for refinancing a mortgage?
There are a number of reasons why someone may choose to refinance their mortgage. This can change from person to person based on their specific financial situation.
In general, people choose to refinance because they can get terms that are more favorable to them.
Here are some of the most common reasons for refinancing a mortgage:
- To get a lower interest rate
- To get a lower monthly payment
- To change the loan payoff terms or repayment period (for example, 30-year to 15-year payoff)
- To change the mortgage type (for example, adjustable-rate mortgage to fixed-rate mortgage or vice versa)
- To tap into the equity in your home (for example, to consolidate debt, to pay for home renovations, or to help with other major expenses)
Let’s explore all of these in more detail, so you can evaluate if any of these factors could help you decide whether or not to refinance your mortgage.
Refinancing to get a lower interest rate
One of the main reasons people refinance is to get a lower interest rate. Based on a variety of economic factors, mortgage rates fluctuate. Over the past 18-24 months, we’ve seen interest rates hover at near-historic lows.
Because of low interest rates, a lot of people have considered refinancing their mortgage. When you refinance your mortgage and get a lower interest rate, you’re effectively reducing the amount of interest you will pay over the life of the loan.
That means by the time you pay off your home, you will have paid less money for it.
In addition to saving money over the life of the loan, reducing your interest rate can also help lower your monthly payment and increase the rate at which you build equity. That’s because a larger amount of your monthly payments will go toward the principal balance instead of interest.
If you’re able to secure an interest rate that’s 1%-2% lower than your current mortgage interest rate, you should consider refinancing. And if the rate is more than 2% lower than your current one, refinancing is pretty much a no-brainer — especially if you’re planning to stay in your home for more than a couple of years.
Refinancing to lower your monthly payment
There may come a time when you need a lower monthly mortgage payment, but you don’t want to move from your home. Refinancing is a potential way for you to accomplish that.
One way would be to refinance at a lower interest rate. If the interest rate is significantly lower, it can have quite an impact on your monthly payment.
You may also get a lower monthly payment if you have improved your credit score since you took out your current mortgage. If you have a much better credit history now — including no late payments on your existing mortgage — you may qualify for a better interest rate than you did when you took out your first mortgage, regardless of the overall interest rate environment.
Another way you can reduce your monthly mortgage payment is by refinancing and lengthening your loan term. For example, let’s say you originally took out a 30-year mortgage and you’ve been paying for your home for 10 years. You could refinance into a new 30-year mortgage. This would spread the remaining balance out over a longer period of time.
Of course, this approach comes with the downside of extending the life of your loan (and likely increasing the total amount of interest you will pay), but it will add some relief for immediate cash flow needs by reducing your monthly payments.
Refinancing to change your repayment period
The most common repayment periods for mortgages are 30 years and 15 years.
You may refinance your existing 30-year or 15-year mortgage into a new 30-year mortgage. By lengthening the repayment period, you will effectively reduce your monthly payment.
You might decide to refinance to a longer loan term if you need extra cash flow, need to build up an emergency fund, or want to direct more money toward investments.
On the flip side, you may be in a position where you want to refinance to reduce your repayment period. For example, a 30-year mortgage can be refinanced into a 15-year mortgage.
You might decide to do this if you’ve been paying on your 30-year mortgage for several years, your credit score has recently improved, your income has increased, and interest rates have dropped.
Historically, 15-year mortgages carry much lower interest rates than 30-year mortgages. The reason why many people choose 30-year mortgages is because of the lower monthly payment.
However, if you’ve been paying on your 30-year mortgage for 5-10 years, you may find that refinancing for a 15-year mortgage won’t make that much of a difference in your monthly payment.
This will allow you to pay off your mortgage more quickly and pay less interest without significantly disrupting your monthly cash flow.
Refinancing to change your mortgage type
There are two common types of mortgage rates: adjustable-rate mortgages (ARM) and fixed-rate mortgages.
You may choose to refinance your mortgage to convert an ARM to a fixed-rate mortgage or vice versa.
ARMs often start with lower interest rates. The downside is they can fluctuate. When interest rates increase (once or multiple times), ARMs can cause a strain on your cash flow and throw a wrench into your budgeting plans.
When we’re in an environment of low interest rates but expect interest rates to increase in the near future — much like we are right now — it makes sense to strongly consider refinancing to convert an ARM to a fixed-rate mortgage.
In this way, you’ve taken advantage of the ARM but create a hedge against higher interest rates by converting to a fixed-rate mortgage before rates go up. This can be especially significant if fixed interest rates are really low and you have several years remaining on your mortgage.
Alternatively, if your fixed-rate mortgage carries a very high interest rate and you’re planning to sell your home in the near future, converting a fixed-rate mortgage to an ARM might make sense.
If you’re planning to move or pay off your mortgage within a couple of years — and economic indicators aren’t pointing toward skyrocketing interest rates — converting to an ARM could significantly lower your interest rate and reduce your monthly mortgage payment.
This would reduce the amount of interest you will pay on your mortgage and help you build equity more quickly. And because you aren’t planning to stay in your home or continue paying the mortgage for long, you won’t be too concerned about future interest rate hikes.
That said, if you are planning to move or pay off your home soon, you’ll want to make sure the interest you save will offset the closing costs incurred by refinancing. We'll cover those costs — and how to determine the break-even point — in more detail later in this article.
Refinancing to access cash from your home’s equity
One final reason you may refinance your home is to tap into your home’s equity.
Known as a cash-out refinance, you can refinance your home for its appraised market value and “cash out” the difference between that value and the remaining principal balance on your current mortgage. This difference is your home's equity.
For example, let’s say you currently owe $100,000 in principal balance on your current mortgage, and you qualify to refinance for a $150,000 cash-out refinance mortgage.
In this case, your refinancing lender would pay off your existing mortgage, create a new $150,000 mortgage, and give you the $50,000 difference in cash (minus any closing costs).
This effectively increases your loan amount, and cash-out refinances usually have higher interest rates than a conventional refinance. That means you’ll likely pay more interest over time, pay a higher monthly payment, and/or pay on your mortgage for a longer period of time.
So, why would you want to do a cash-out refinance? Here are a few reasons it might make sense.
Cash-out refinance to consolidate or pay off debt
If you have a lot of debt — particularly high-interest debt like credit cards or student loans — and you’re unable to pay it off with your existing savings or cash flow, you might consider a cash-out refinance to pay it off.
The main reason you’d want to do this is because mortgage rates are typically much, much lower than other types of interest rates (namely credit cards). By doing a cash-out refinance, you can convert the equity in your home into cash to pay off the high-interest debt.
This effectively acts as an interest rate swap, where you’re dramatically reducing a high interest rate into a lower interest rate without increasing the amount of debt you owe. Over time, you’ll save a lot of money in interest and likely pay off your debt sooner since you’ll be able to pay down more principal instead of interest.
The added benefit is that this will also help consolidate your debt, so you’ll have fewer accounts to keep track of and fewer bills to pay each month.
It is important to note, though, that a cash-out refinance is still a loan. The only way to make it work in your favor is to make sure you don’t rack up new high-interest debt after the cash-out refinance.
If this happens, you’ll still have the additional debt that’s been added to your mortgage, less equity in your home, a higher monthly mortgage payment, and additional high-interest debt. This will ultimately make it even more difficult to get back on the right financial path.
Refinancing unsecured debt (e.g., credit card) into secured debt (e.g., mortgage) only makes sense when you have the financial stability to afford the higher mortgage payment. The potential consequences for not being able to make credit card payments (i.e., a drop in your credit score) are far less than not being able to make your mortgage payment (i.e., losing your home in the foreclosure process).
Cash-out refinance for home improvements or major expense
Whether it’s an expensive, unexpected home repair or a planned renovation, you may choose a cash-out refinance to fund your project and invest in your home.
If you don’t have the money saved up or cash flow to support these projects in full, a cash-out refinance is likely a better option than a personal loan or credit card, which typically come with higher interest rates than mortgages.
An added benefit is that investments in your home usually add value to it. So when it comes time to sell, you may be able to recoup your costs (and then some).
That said, you’ll want to make sure the amount of cash you receive is worth the amount it’ll cost to refinance and aligns closely with the cost of your home project.
Beyond home projects, you may want to access the equity in your home to cover other major expenses, like a wedding or pay for your child's education. The interest rate on your mortgage is likely to be much lower than other lending sources, like personal loans, credit cards, or student loans.
Cash-out refinance to save more for retirement
It may sound counterintuitive at first, but sometimes it’s a good idea to do a cash-out refinance and use the equity in your home to save more for retirement.
There’s a big opportunity cost that comes with paying a mortgage, and it’s important to balance the rate at which you pay down your mortgage with the rate you could be investing into your retirement savings.
If you’re a young professional and you’re not currently maxing out your 401(k) or Roth IRA, a cash-out refinance might make a lot of sense, especially if your monthly cash flow allows you to manage a higher mortgage payment.
In recent history, the rate of return on retirement investments have been notably higher than mortgage interest rates. When this is the case, the money you invest from your cash-out refinance will grow (and compound) more quickly than the additional interest on your refinanced mortgage.
The sooner you start to save and invest, the sooner you’ll start building and taking advantage of compounding interest.
But remember, a cash-out refinance will almost certainly increase your monthly payment and the amount of interest you will pay. It’s only worth doing if your cash flow can support the higher monthly payment. Otherwise, you’ll be putting yourself at risk of losing your home if you’re unable to afford the new payment.
How much does it cost to refinance your mortgage?
Just like your original mortgage, refinancing comes with associated closing costs. While the specific expenses can vary from person to person, market to market, and lender to lender, you can expect to pay anywhere between 3% to 6% of the remaining principal on your mortgage in closing costs.
For example, if you currently owe $200,000 on your existing mortgage, it would likely cost $6,000-$12,000 in closing costs to refinance.
Here’s what’s typically covered in the closing costs:
- Attorney fees
- Loan origination fees
- Loan application fee
- Home appraisal
- Title search and insurance
- Discount points (if desired) to lower your interest rate
Additionally, you may want to look out for early prepayment penalties in your current mortgage. Although relatively rare, some mortgage lenders charge a fee for early prepayment, which would happen when you refinance.
Often, when early prepayment penalties are a part of your current mortgage, refinancing won’t be the most financially optimal solution for you. It’s best to know about these fees upfront so you don’t waste too much time and effort toward refinancing only to be surprised by the final closing costs and prepayment fee.
When you apply for a refinancing quote, you should receive a loan estimate so that you can clearly see the closing costs, compare them with other lenders as you shop around, and evaluate whether or not refinancing is the best option for you.
As you can see, refinancing can be quite expensive. In some cases, you may be able to roll the closing costs into your new mortgage. While this reduces the amount of upfront costs associated with refinancing, it will increase your loan amount. This increases your monthly payment and the amount of interest you will pay over the life of the loan.
To determine the break-even point of your refinance — that is, at what point the savings of refinancing will begin to offset the costs — you can divide the total loan closing costs by the amount you’ll save each month on your new payment.
For example, if your closing costs are $5,500 and you save $250 per month on your new mortgage, your break-even point is 22 months (5,500/250 = 22). If you plan to stay in your home for longer than 22 months, it likely makes sense to refinance.
When is the best time to refinance your mortgage?
There’s not a single moment in time that’s the best for refinancing your mortgage. There’s also a difference between the right time when you want to refinance and when you need to refinance.
If you’re in a position where you’re financially strained and need access to cash, it may be the right time to refinance so that you can access the equity in your home or refinance to a longer term to reduce your monthly payment.
Let’s say you don’t necessarily need to refinance, but you’re looking for opportunities to benefit from refinancing. In that case, some of the best times to do so are:
- When interest rates drop or are historically low
- When interest rates are expected to increase soon (especially for those who want to convert an ARM to a fixed-rate mortgage)
- When a cash-out refinance could help you maximize your retirement savings, pay off high-interest debt, or fund a major expense or home repair
- When your credit history has improved significantly since you applied for your current mortgage
Conversely, here are some of the worst times to refinance:
- When you plan to move soon
- When you’re within a couple of years of paying off your mortgage
- When your recent credit history is worse than when you originally applied for your current mortgage
- When interest rates are historically high
- When you face an early prepayment penalty
We advise against trying to “time” interest rates, as they are difficult to predict and don’t vary widely on a day-to-day basis. Instead, we recommend checking in on interest rates every 6-8 months. When you see that they’re 1%-2% lower than your current rate, you may want to explore refinancing.
Who is eligible to refinance a mortgage?
As long as you currently hold a mortgage, aren’t upside-down on your mortgage (meaning you owe more than your home is worth), and you have at least 20% of equity in your home, you’re eligible to refinance.
Beyond these basic qualifications, many lenders will also typically require proof of income and good credit history.
How often can you refinance your mortgage?
So long as you meet the qualifications and a lender is willing to underwrite your refinance, you could theoretically refinance as often as you want.
That said, every time you refinance, you’ll incur closing costs. Unless rates drop dramatically or you’re in dire need of cash, it probably won’t make sense to refinance more than one time within 5-10 years.
How to refinance your mortgage
Just like your original mortgage process, refinancing can take some time (usually between 30-60 days). Although somewhat time-consuming, it is relatively straightforward.
To make the process easier, we almost always suggest working with a mortgage broker, local bank, or credit union. Some of our recommended local mortgage lenders are Athens Mortgage Resources, BOE Classic Lending, First American Bank & Trust, and Remarkable Mortgage.
Mortgage brokers and local lenders are very experienced in the refinancing process. They’ll know exactly what you need to do to have as smooth of an experience as possible and can help you identify the best available lending rates.
Many people make the common mistake of not shopping around. Instead, they’ll simply contact their current lender and ask them about refinancing. While this may work out in some cases, it usually isn’t the financially optimal solution. We recommend getting loan estimates from multiple mortgage brokers and local lenders.
Your general steps to refinancing are:
- Evaluating your current mortgage, cash flow needs, and average interest rates to determine if it’s likely to make sense for you to explore refinancing
- Decide what type of mortgage you may want to refinance into (i.e. converting ARM to fixed-rate, shortening the loan term from 30 years to 15 years, etc.)
- Engage multiple mortgage lenders to get loan estimates and provide necessary documents
- Review loan estimates and select the lender that presents the best mortgage option for your needs
- Lock in your interest rate
- Review the final closing statement a few days before closing to make sure it aligns closely with the loan estimate
- Sign the closing paperwork
At Elwood & Goetz, our financial planning team works with clients to help identify the best refinancing options and interest rates based on their specific needs and financial situation.
Alternatives to refinancing
If you don’t want to refinance your home or if it simply isn’t the most financially optimal option for you, there are some other options for leveraging your existing mortgage to your benefit.
For example, one of the most common alternatives to a cash-out refinance is a Home Equity Line of Credit (HELOC). Like a cash-out refinance, HELOCs help you access cash by tapping into your home’s equity.
Unlike fixed-rate cash-out refinances, HELOCs charge a variable interest rate. Based on the interest rate environment and fluctuations, HELOCs could end up being more expensive than cash-out refinancing.
That said, one major benefit to HELOCs is their flexibility. With a HELOC, you can open a line of credit and leave it open without taking any money against it. That means the money is there when you need it, but you’re not forced to take it at any time. And you won’t be charged any interest unless you’re actually accessing the line of credit.
A HELOC works much in the same way as a credit card, except a HELOC’s interest rate is likely to be much lower. Additionally, HELOCs are a form of secured debt because your home is collateral.
Credit cards, on the other hand, are unsecured debt, because there’s no collateral. With unsecured debt, there’s much higher risk for the lender and with that, much higher interest rates for borrowers.
A HELOC is likely to make more sense for homeowners who aren’t sure exactly how much money they need or when they will need it. A HELOC will also make sense for someone who is close to paying off their mortgage or is planning to move soon since they don’t incur closing costs like cash-out refinances do.
Conclusion: How do I know if I should refinance my mortgage?
There are a lot of different factors specific to your financial situation, goals, and cash flow needs that will determine whether or not you should refinance your mortgage.
That said, here are some general guidelines that indicate you should really look into refinancing your mortgage:
- If refinancing into a new mortgage will give you a notably lower interest rate (1%-2%) and/or lower monthly payment, and you plan to live in your home beyond the break-even point (closing costs divided by monthly savings).
- If a cash-out refinance allows you to pay down high-interest debt, maximize your retirement savings accounts, or fund a major expense without raising your monthly mortgage payment to an amount you cannot comfortably afford.
- If your cash flow has been negatively impacted and you need to refinance to reduce your monthly payment.
- If you currently have an adjustable-rate mortgage, interest rates are expected to increase significantly in the near future, and you plan to stay in your home for the foreseeable future.
There are also some clear examples of times when you almost certainly shouldn’t refinance. For example, if the savings are minimal but drastically lengthen the amount of time you’ll be paying a mortgage, if you’re planning to move soon, or if you’re within 2-3 years of paying off your mortgage.
As of February 2022, interest rates remain near historic lows. But we don’t expect that to be the case for much longer. The Federal Reserve has already indicated they anticipate multiple increases to the federal funds rate — the interest rates banks charge each other for short-term loans — this year. That will have a domino effect on mortgage rates, too.
Yes, refinancing takes effort. And it isn’t necessarily cheap. But by taking advantage of the benefits of refinancing your mortgage, you could save a significant amount of money over the long-term, have more money to invest toward retirement, and put yourself in a much stronger financial position.