When Should I Refinance My Mortgage Loan?

If you own your home, refinancing your mortgage is probably the most profitable move you can make to take advantage of low interest rates. Because a lower interest rate means a lower-cost loan overall, a lower interest rate is always a boon for refinancing applicants, even if it’s not the primary objective.

And there are plenty of good reasons to refinance a mortgage beyond locking in a lower rate. It can allow you to cancel your Federal Housing Administration (FHA) mortgage insurance, restructure a jumbo loan as a conventional loan to accelerate your progress toward free and clear ownership, or use the equity you’ve built up in your home to finance a home improvement project.

But does the fact that you can easily find a good reason to refinance your mortgage mean you should actually do it?

It depends. If you’re confident you can save more over the life of your refinanced loan than you’ll pay in closing costs and other incidental expenses, refinancing makes sense from a financial standpoint. If the comparison between your original loan and your new loan isn’t apples-to-apples, perhaps because the new loan has a longer term or includes a cash-out component, then its benefits (such as a lower monthly payment or low-cost, high-dollar financing) must outweigh the costs.

Before you can determine that, you must learn more about why you’d want to refinance your mortgage, how to calculate the net costs of refinancing, and when you can answer yes to the question, “Should I refinance my mortgage?”

Pro tip: If you’re thinking about refinancing your mortgage, check out Credible to find some of the lowest rates. Within minutes, you’ll receive prequalified rates from multiple lenders.

Common Reasons to Refinance a Mortgage

The most common reasons to refinance a mortgage include:

• Lowering the loan’s monthly payment
• Lowering the loan’s interest rate or avoiding a rate increase
• Accelerating the loan’s payoff
• Canceling FHA mortgage insurance
• Dropping a former spouse from the mortgage
• Tapping the equity in the home

If any of these reasons sound appealing, your answer to the question of whether you should refinance your mortgage is still only a tentative yes.

Don’t call your loan officer just yet. First, understand what each refinancing objective really entails, how aspects of your borrower profile (such as your credit score) could affect your approval chances and refinance loan rate, and whether it’s the right time to pull the trigger.

Lowering Your Monthly Payment

Getting a lower monthly payment is one of the most common reasons to refinance a mortgage. It’s often incidental to other refinancing objectives, such as canceling FHA mortgage insurance premiums or avoiding an adjustable-rate mortgage’s looming interest rate increase.

Achieving a lower monthly payment is much easier when prevailing interest rates are lower than they were when you applied for your first mortgage. If your credit score, income, and debt-to-income ratio (your eligible debts divided by your gross income) remain the same or have improved since then and you’ve built at least 20% equity in your home, you probably won’t have any trouble qualifying for a lower interest rate when prevailing rates are low. Lower credit, income, or equity or higher debt-to-income could result in less favorable terms despite lower prevailing rates.

A lower interest rate doesn’t guarantee a lower monthly payment, however. Your lender is almost certain to offer to roll your loan’s closing costs into its principal, sparing you an out-of-pocket payment at closing. Closing costs on conventional refinance loans typically range from 2% to 6% of the refinanced amount, likely adding thousands to the principal and a not-insignificant amount to your monthly payment.

If your original mortgage is less than five years old, your refinance could also trigger a prepayment penalty — up to 5% of the balance in some cases but more likely under 3%. Still, that’s a big hit. The combination of closing and prepayment costs is why experts recommend thinking twice about refinancing to a rate less than 150 basis points lower than the original mortgage when the main objective is a lower monthly payment.

If interest rates aren’t appreciably lower when you refinance, you can still lower your monthly payment by lengthening your loan’s term. For instance, if you’ve been paying your 30-year mortgage for eight years and therefore have 22 years left on the term, refinancing the remaining balance into a new 30-year loan spreads out the loan’s payments over eight more years and probably achieves a lower payment. But you’ll pay more interest over the life of the loan and take longer to attain free-and-clear homeownership — a key goal for most homeowners expecting to remain in their houses for the long haul. Typically, refinancing applicants refinance into loans with terms equal to the remainder of their original loans’ terms.

Reducing the Total Amount of Interest Paid

A lower interest rate is often a prerequisite for (and incidental to) achieving a lower monthly payment. But sometimes, the lower interest rate is a means to another important goal: reducing the total amount of interest paid over the life of the loan.

The most effective way to reduce the total amount of interest paid over the life of your loan is to refinance into a shorter term. For instance, in the example above, you might refinance your 30-year loan with 22 years remaining into a 15-year loan, shaving seven years off your total repayment time. Shorter-term loans often carry lower interest rates, magnifying the potential savings.

The upshot of a shorter loan term is usually a higher monthly payment. If your budget has limited room to absorb a higher payment, refinancing into a shorter loan term isn’t feasible unless you can find expenses to cut or means to earn extra income over the long term.

Refinancing a Jumbo Loan Into a Conventional Loan

Because Fannie Mae and Freddie Mac don’t guarantee them, nonconforming jumbo loans are riskier for lenders. Accordingly, they almost always carry higher interest rates than conforming (conventional) loans.

If your jumbo loan’s remaining balance is lower than the conforming loan limit of about $485,000 (higher in expensive real estate markets), you could significantly reduce your interest rate and lifetime interest costs by refinancing into a conventional loan. Your new loan must remain below the conforming loan limit after accounting for any rolled-in closing costs.

Accelerating Your Loan’s Payoff

Accelerating the payoff is another job for shorter-term refinance loans. Again, you must crunch the numbers to confirm a higher monthly payment works within your budget’s constraints. If not, some difficult cost-cutting choices could loom.

Avoiding an Upward Rate Adjustment

An adjustable-rate mortgage (ARM) seems like a good deal at first. During the initial term, typically five to seven years, the interest rate remains fixed, often at a level lower than rates prevailing on 30-year mortgages.

The reckoning comes at the end of the initial term, when the rate is eligible to adjust for the first time. If prevailing interest rates have increased in the interim, the rate increases — and could increase (or decrease) each year thereafter, depending on the loan’s terms.

Though caps on rate and payment increases provide some protection for borrowers, ARM rate increases can still be difficult to absorb. That’s why many ARM borrowers choose to refinance into conventional fixed-rate loans before the first rate increase. Even accounting for a prepayment penalty, this move could dramatically reduce borrowing costs when prevailing rates are high while guaranteeing a measure of predictability around future mortgage payments.

Getting Rid of Annual FHA Mortgage Insurance

Getting rid of FHA mortgage insurance is another refinancing objective that can reduce lifetime borrowing costs. Accordingly, it’s best to do it as soon as possible. Annual FHA mortgage premiums can exceed 1% of the loan principal, depending on the term, issue date, and original down payment.

Annual FHA mortgage insurance premiums remain in force for the life of loans with the following characteristics:

• Issued after June 3, 2013
• Initial down payment of less than 10% of the home’s value

The only way to get rid of annual mortgage insurance payments on these loans is to refinance into a conventional loan once you’ve achieved at least 20% equity.

FHA loans issued after June 3, 2013, with down payments greater than 10%, carry annual mortgage insurance for 11 years. Depending on the size of your down payment and loan term, you should reach 20% equity well before that point.

Understand that refinancing from FHA to conventional won’t retroactively eliminate the 1.75% upfront mortgage insurance premium charged on all FHA loans. If you rolled that balance into your original loan’s principal, it carries over to your refinanced loan.

Tapping the Equity in Your Home

Taking advantage of your home’s equity becomes more realistic with each passing year, assuming your home’s market value remains stable or increases over time.

A refinance loan that allows you to tap the equity in your home is known as a cash-out refinance. You can use the cash to finance a home improvement or repair project, consolidate higher-interest debt, or cover major life expenses like college tuition.

Some lenders issue cash-out refinance loans up to 85% of the appraised home value, but most cap principals at 80%. In other words, to determine roughly how much cash you can extract in a cash-out refinance, you must:

• Determine your home’s current market value (a reasonable estimate of its likely appraisal value)
• Subtract 20% of that value
• Subtract the balance remaining on your original mortgage

Clearly, equity is your friend here. The more you have, the more cash you can borrow.

Dropping a Former Spouse or Partner From the Title

Removing a former partner’s name from your mortgage is more of a practical matter than a money-saving move. However, it can certainly reduce your monthly payment and lifetime borrowing costs if rates have fallen since your original mortgage’s issue. Either way, chalk this up as one more cost of getting divorced.

If you need to refinance your mortgage to drop your former spouse or partner from the title, do so as soon as possible after agreeing that you’ll keep the house. Understand that you need to qualify for the loan on your own with no help from your former spouse’s credit score or income (as was most likely the case for the original mortgage). If you expect this to be difficult, you can get a cosigner or sell the home outright.

Calculating Your Projected Savings & Breakeven Point

You won’t know for sure whether it makes sense to refinance your mortgage until you know about how much you can save by doing so and how long you must carry the new loan until you break even.

Calculating Your Refinance Loan’s Costs & Projected Savings

Refinance loans always carry closing costs. Many trigger the original loans’ prepayment penalties.

Closing costs typically range from 2% to 6%. That’s a pretty broad span — a difference of $8,000 on a $200,000 loan. You won’t have a good idea of where your closing costs will fall until you actually apply for your loan. Even then, the exact amount will likely vary right up until you close.

Still, you can get a sense for how much your loan will cost before you apply by adding up your possible and likely closing costs:

• An origination fee as high as 1.5% of the loan value
• An appraisal fee not likely to exceed $500
• Title insurance premiums likely to range between $400 and $1,000 (possibly lower for “reissue” title insurance)
• A Settlement fee not likely to exceed $1,000
• Discount points, which cost 1% of the loan value for a 0.25% interest rate reduction

These costs can really add up. The silver lining is that they’re very unlikely to approach what you paid to close your purchase loan, as some big-ticket purchase closing costs don’t apply to refinances: for example, broker commissions, title search, home inspection, and transfer fees.

Once you have a closing cost estimate, calculate your original loan’s prepayment penalty, if any. Your loan documents have all the information you need to do this, and your servicer’s website probably does as well. If you have any questions, call your servicer directly for a straight answer.

Most often, the prepayment penalty is a multiple of a portion of monthly interest paid — for instance, 80% of interest paid over six months.

From here, finding the upfront financial cost of your refinance is straightforward. Just add your total cost to close to your prepayment penalty. Do this again once you apply using the firmer numbers you receive in your loan disclosure.

Calculating Your Breakeven Point

Next, you need to calculate your breakeven point. If your refinancing objective is primarily financial — that is, you don’t need to remove a former spouse from the title or achieve some other nonfinancial goal — then refinancing doesn’t make sense if you won’t break even on the loan.

In practice, refinancing might not make sense even if you just break even on the loan. The process itself is time-consuming and grates on the nerves. However, precisely how much you need to save to justify the effort is a question only you can answer.

To calculate your likely breakeven point before you apply, use a mortgage refinance calculator (Bank of America’s works well). Find your expected monthly principal and interest payment by entering your refinance loan’s interest rate, term, and principal. Add in your monthly property tax, insurance, and HOA fees (if applicable) using information from your current mortgage servicer. These numbers typically remain constant in the short term, though they’re likely to change over time. Subtract any monthly costs that won’t apply to your refinance loan, such as your annual FHA mortgage insurance premium.

Next, subtract the result — your refinance loan’s expected total monthly payment — from your current mortgage’s monthly payment. This number is how much you expect to save each month by refinancing.

Finally, divide your refinance loan’s total cost by your expected monthly savings and round up to the nearest whole number. That’s the number of months it’ll take you to break even on your refinance loan, assuming no changes to your original loan’s interest rate or other components of your monthly payment.

If your breakeven point looks to arrive sooner than your original loan’s expected payoff date or the earliest date on which you plan to sell your home, you can save money in the long run by refinancing. The longer you remain in your home, the more you can save.

Final Word

If you have a clear refinancing objective in mind and you expect to remain in your home long enough to break even on your new loan, refinancing your current mortgage is probably the right move.

Even if you don’t expect to break even on your refinance loan because the loan’s purpose (say, financing a major home improvement project) isn’t compatible with that goal, you should refinance your mortgage if you fully understand what you’re signing up for. That’s all the more true in a low-rate environment, when refinancing costs are lower at a baseline than when prevailing rates are higher. After reviewing the pros and cons of refinancing a mortgage loan and becoming familiar with the actual mortgage refinancing process, you’re now ready to strike while the iron’s hot.

Are you weighing whether to refinance your mortgage? Why?