If you've got a home loan that your no longer happy about, you might be able to refinance the mortgage—that is, replace the loan with a better one. The mortgage refinancing process can save you money and hassles, but sometimes it's just an expensive mistake. If you’re considering refinancing your home loan, you should know how it affects you before you pull the trigger.
What a Mortgage Refinancing Involves
Refinancing involves swapping out your current mortgage for a new one. Homeowners typically refinance a mortgage to secure more favorable interest rates or other loan features that can save them money or make payments more sustainable over the long run.
The steps you must take to refinance a mortgage will be similar to the ones you took to get your current loan:
- Determine the desired loan features: Whether your aim is to secure lower interest rates, switch to a fixed interest rate, or extend your loan term, it's important to establish the specific interest rate or term length you want in advance.
- Settle on a lender: You don't have to choose your current mortgage loan provider for a mortgage refinancing. Shop around for a qualified lender who offers the terms you seek. Get at least three to four loan quotes before you choose one. Don't be afraid to bargain on negotiable loan terms, including interest rates, closing costs, and other fees.
- Apply for a loan: If approved, review the loan terms and fees in the contract so that you know what to expect and avoid surprise costs.
- Start repaying the new loan: You'll continue to make payments on the refinanced loan until you pay it off or refinance it again.
If you're not sure what loan features you need, use a loan amortization calculator to see how your payment would change with a different interest rate or loan term.
Benefits of Refinancing
A restructured loan can improve your financial situation in several ways:
- Lower monthly payments: When refinancing your mortgage with a lower interest rate or a long term loan, you'll generally achieve lower, more manageable monthly payments.
- Lower lifetime interest costs: If you refinance your loan with a lower interest rate, you'll pay less in interest costs over its lifetime, which reduces the total loan cost.
- Fixed rates and monthly payments: The benefits of switching from an adjustable-rate mortgage (ARM) to a fixed-rate loan are two-fold: You can prevent the interest rate on the loan from increasing in the future and ensure predictable monthly payments.
- Cash for other purposes: If you refinance with a loan that is more than the amount you owe, you can receive a cash payment for the difference, which is known as cash-out refinancing. You can use the cash for home improvement or long-term financial goals.
- Debt consolidation: The cash you receive from a cash-out refinancing can also be used to pay off other debts, which can reduce the total number of debts you owe and make loan repayment more manageable.
A cash-out refinancing reduces the equity, or ownership, in your home, which means that you won't pocket as much after you sell it.
Drawbacks of a Mortgage Refinancing
Refinancing can also have negative financial impacts if you don't carefully evaluate the terms of the restructured loan:
- Unfavorable terms: A better loan isn't guaranteed. For example, if your credit is lackluster at the time of application, or market interest rates have increased, you might not be approved for a loan with lower interest rates.
- Higher lifetime interest costs: Your total lifetime interest costs might increase if your new loan term is the same as your current mortgage. If you had paid on your current 30-year mortgage for 10 years, then refinanced for another 30 years, you would be paying 40 years' worth of interest.
- Higher monthly payments: If you do a cash-out refinancing, the new loan amount will be more than you owe with the old one, resulting in higher monthly payments.
Costs to Refinance
Mortgage refinancing isn't free. You’ll pay several fees to your new lender and other professionals to compensate them for processing the loan. Some of the fees included in refinancing are:
- Application fees: This expense covers the cost to process your loan and perform credit checks.
- Origination fees: This is a one-time fee that you pay for loan preparation.
- Appraisal fees: This covers the cost of an appraisal to assess the value of your home.
- Inspection fees: You'll be charged this fee if your home requires an inspection to assess its condition.
- Closing costs: This includes fees for the attorney who handles the closing of the loan on behalf of the lender.
Altogether, refinancing fees generally amount to 3%–6% of the remaining principal on the mortgage.
Even if your lender doesn't require you to pay the above fees upfront—for a "no-cost refinancing," for example—you’re still paying those fees (even if you don't notice them), usually through a higher interest rate.
Deciding Whether to Refinance
You need to weigh the pros and cons of your old loan and a new loan to decide whether it's worth the cost. One way to do so is to do a basic break-even analysis, which helps you determine how much you’ll save over time and how long it will take to recoup any up-front costs.
In general, mortgage refinancing is a good move when you’ll truly benefit financially from a new loan and a bad move if you'll waste money or increase risk when you refinance.
When to Move Forward
Some clues that a mortgage refinancing is worthwhile are:
- Interest rates are low: Changes in market conditions may allow you to secure a lower interest rate when you refinance a mortgage.
- Your credit has improved: Credit score increases can make you eligible for a lower-interest loan.
- You plan to stay in the home for a long time: Refinancing a mortgage makes sense if you plan to live in the home long enough to recoup the costs of restructuring the loan.
- You can avoid getting stung by a high-risk mortgage: Risky mortgage loans, such as an ARM with an APR that is much higher than the introductory rate, can cause your monthly payments to soar and increase the risk of default after the introductory period. In this case, switching to a fixed-rate loan can minimize the risk of default.
- Getting an amortizing loan vs. interest-only loan: As in the case of ARMs, a loan with payments that only covers interest during the initial period can result in payment shock after the interest-only period, where payments go up dramatically. You can avoid this costly surprise if you refinance with an amortizing loan, which includes proportional interest and principal in the payments.
When to Hold Back
You should avoid refinancing your mortgage in other cases:
- Lifetime loan costs might be higher: Securing a lower monthly payment may save you money in the present but may cost you more in the long run.
- You plan to move in a few years: If you leave quickly, your savings from the refinancing may not be enough to recoup the costs of refinancing, making refinancing a losing financial proposition.
- If there are prepayment penalties: This is a fee charged by some lenders when you pay off a loan before the end of the loan term. If you can't get the lender to waive this penalty, it will add to the total loan costs.
The Bottom Line
Refinancing allows you to replace an unsatisfactory or unsustainable home loan with one you can live with over the long run. While the process can result in lower monthly payments and other terms that make payments more manageable, it can also leave you worse off financially in certain scenarios. It's crucial to pit the benefits against the drawbacks, and then run the math on the savings and costs. This will help you determine whether it's the right approach and right time for you.
Board of Governors of the Federal Reserve System. "A Consumer's Guide to Mortgage Refinancings." Accessed March 17, 2020.
Board of Governors of the Federal Reserve System. "Interest-Only Mortgage Payments and Payment-Option ARMs — Are They for You?" Page 12. Accessed March 17, 2020.