When is refinancing a mortgage worth it?

Young couple leaning against a white backdrop with a laptop while discussing whether they should refinance their mortgageImage: Young couple leaning against a white backdrop with a laptop while discussing whether they should refinance their mortgage

In a Nutshell

Refinancing a mortgage can help you save money on your monthly mortgage payment, but you’ll want to weigh the money you’ll save against the actual cost of refinancing your home loan.
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Refinancing your mortgage can be a smart financial move, potentially saving you money on your monthly mortgage payment or on total interest over the life of your home loan.

Before you apply, you’ll want to think carefully about when to refinance your mortgage. You’ll also want to decide if refinancing makes sense financially by weighing any money you’ll save against the cost of refinancing the loan.

We’ll review some common scenarios to think through.

When does it make sense to refinance?

In general, refinancing will likely make sense when it makes sense for your finances. But part of that depends on your financial goals. For instance, do you want a lower monthly payment? Are you trying to save in total interest paid? Do you need to extract cash from your home with equity you’ve built?

Here are five situations to think about before you refinance.

1. Mortgage rates have gone down

Mortgage rates can fluctuate since they’re impacted by a variety of factors, including U.S. Federal Reserve monetary policy, market movements, inflation, the economy and global factors.

If mortgage rates fall, you may be able to save by securing a lower interest rate than you have on your existing loan.

So how much should mortgage rates fall before you consider refinancing? The traditional rule of thumb says to refinance if your rate is 1% to 2% below your current rate.

Make sure to factor in your current loan term when considering refinance though. For instance, if you’re four years into a 30-year mortgage and refinance to a new 30-year term, it will have taken you 34 years total to pay off your home in the end. Plus, you’ll likely pay more interest over the extended term than if you had chosen a shorter term.

No matter what rates are doing, you’ll want to check that the math works out in your favor.

“Make sure to calculate your break-even point and how the overall costs — including total interest — of your current mortgage and your new mortgage would compare,” says Andy Taylor, general manager for Home/Mortgage at Credit Karma.

Use our refinance calculator to determine if refinancing your mortgage is financially worth it.

2. Your credit has improved

Your credit is a significant factor in determining your mortgage rate. Generally speaking, the better your credit is, the lower the interest rate you’ll receive.

Let’s look at an illustration based on recent interest rates. If you have a 30-year fixed-rate mortgage of $150,000 and your FICO credit score is within the 660 to 679 range, the myFICO Loan Savings Calculator estimates you could pay 2.969% APR (based on interest rates as of Oct. 21, 2020).

With this interest rate, your monthly payment would be $630 and your total interest paid across 30 years would amount to $76,764.

In comparison, if your credit score was in the 700 to 759 range, the calculator estimates your monthly payment would drop to $599 (based on rates as of Oct. 21, 2020). Over the life of the loan, you could save $11,202 in interest.

3. You want a shorter loan term

If you’re keen to pay off debt, you may want to refinance your mortgage to a shorter loan term. You could add to your savings if you can secure a lower interest rate and shorten your term. A shorter loan term means you’ll pay less in total interest.

But one word of warning: You’ll probably be increasing your monthly payment in exchange, so make sure it fits into your budget. You don’t want to risk defaulting on your loan.

4. Your home value has increased

If the value of your home has gone up, you might also get some benefit from refinancing, especially if you have other high-interest debt to pay off or another financial goal.

A cash-out refinance lets you take out a new mortgage that’s larger than what you previously owed on your original mortgage, and you receive the difference in cash. A cash-out refi is an alternative to a home equity loan.

You also might consider a cash-out refi for home improvements or to pay for a child’s education.

But you’ll want to make sure you don’t end up paying more in mortgage interest than the interest you would pay on any debt you’re using the cash to pay off.

5. You want to convert from an adjustable rate to fixed

If mortgage rates are increasing and you currently have an ARM — or adjustable rate mortgage — you may want to consider refinancing and converting to a fixed-rate mortgage. That’s because with an ARM, your rate may increase beyond what you’d pay with a fixed-rate mortgage. If you’re concerned over future interest rate hikes, a fixed-rate mortgage could provide some peace of mind.

When should you reconsider refinancing your mortgage?

There are a few situations when you might want to rethink refinancing your home.

  • Prepayment penalty — If your existing mortgage has a prepayment penalty, consider if you’ll save enough to make paying the penalty fee worth it. And ask your lender if it’s willing to waive the penalty if you refinance your mortgage with it.
  • Moving soon — Do you already have your eye on a new home? Calculate your break-even point (more on that below) to make sure you won’t lose money once you factor in the costs of refinancing.
  • Existing home equity loan — If you have a home equity loan or line of credit (or HELOC), you may have to ask that lender’s permission to refinance your loan. If it doesn’t agree, you might have to pay this account off before you can refinance.

More tips to figure out if refinancing is right for you

Calculate your break-even point

Figure out how long it may take for your refinance to pay for itself. To do this, divide your mortgage closing costs by the monthly savings your new mortgage will get you. If you’re paying $5,000 in closing costs but you’ll save $200 per month as a result of refinancing, it will take you 25 months to break even.

If you don’t plan on staying in your home past the break-even point, it probably doesn’t make sense to refinance.

Factor fees into the picture

Refinancing a mortgage can be expensive. Here are some typical fees you may have to pay.

  • A mortgage application fee (which might range from $250 to $500)
  • Origination fee (about 1% of your loan value)
  • Appraisal fee ($300 to $600)

Make sure you know what costs to expect and whether you can afford them.

Consider the term of your new loan

Before you decide to refinance, calculate your break-even point and how the overall costs — including total interest — of your current mortgage and your new loan would compare.

Take note that refinancing usually makes more sense earlier into your mortgage term.

In the early years of your mortgage term, your payments are primarily going toward paying off interest. In the later years, you begin to pay off more principal than interest, meaning you start to build up equity — the amount of your home that you actually own.

Once you refinance, it’s like you’re starting over. Say you’ve been paying off your old mortgage for 10 years, and you have 20 years to go. If you refinance into a new 30-year mortgage, you’re now starting at 30 years again.

Figure out whether you’re willing to invest the effort

Refinancing, just like applying for a mortgage, can take significant time and effort. You may need to obtain additional paperwork and spend time understanding your options, so consider whether the savings you could receive make up for this extra effort.

Know where your credit stands

Since your credit can affect your interest rate, you should know what kind of shape it’s in. If it’s not in great standing, you may want to take steps to improve it before you refinance.

About the author: Mika Bhatia is an Editorial Content Strategist for Credit Karma. She's worked in financial services and tech, and has now found the perfect union of the two at Credit Karma. When she's not busy strategizing about cred… Read more.