When Should You Refinance Your Mortgage?

When to Refinance Your Home

A mortgage refinance is when you replace your existing home loan with a new one—usually one with different terms, such as a lower interest rate or shorter term. Refinancing can also be used to tap into your home equity to borrow cash.

While these benefits can be substantial, refinancing has tradeoffs. It's best to proceed only when the timing and circumstances are right. Here are scenarios when it may make sense to refinance.

To Get a Lower Interest Rate

One of the primary reasons to refinance is to save money on interest. You may qualify for a lower interest rate if rates have dropped or your credit score has increased since you took out your mortgage, or if you'll be adding a co-borrower whose income and credit score make you eligible for better rates and terms.

Example: Let's say you currently have a $200,000 mortgage balance with a 30-year term and a 7% annual percentage rate (APR). You currently pay $1,330 per month. Here's what it looks like when you refinance to a 6% rate and a new 30-year term:

In this example, you'll save $131 per month and more than $47,000 in total interest. These calculations assume you paid $4,000, or 2% of the loan amount, in closing costs when you refinanced. You'll break even, meaning you'll recoup the cost of refinancing with interest savings, after 24 months.

Here's an example when refinancing wouldn't make financial sense. Let's say you qualify for an interest rate of 6.5% (instead of 6%), and your closing costs come to a total of $12,000 (instead of $4,000).

You'll save $23,711 in interest over time, but only $66 per month. Since your closing costs are higher, the effective APR after refinancing will be higher than your original interest rate. Additionally, it will take more than 20 years to break even on the loan.

To Change Your Loan Term

You can also refinance to shorten or lengthen your loan term. When refinancing a mortgage, you may have the option to choose from 10-, 15- or 30-year terms. You may refinance to a longer term in order to make lower monthly payments, but that will mean paying more in total interest. On the other hand, you could refinance to a shorter loan term to pay off the loan faster or to get a better rate, since shorter mortgages often come with lower interest rates. With a shorter loan term, you may pay more per month, but your overall savings could be substantial.

To Change Your Loan Type

Refinancing also allows you to convert a government-backed loan to a conventional loan. You may want to take this step if, for example, you have an FHA loan guaranteed by the Federal Housing Administration and you made a down payment of less than 10% when you purchased the home. In this case, you'd pay mortgage insurance for the entire loan term. But refinancing to a conventional loan would allow you to get rid of mortgage insurance once you have 20% equity in the home, meaning you've paid off enough of the loan to own 20% of the home's value.

To Use Equity

When you opt for a cash-out refinance, you take out a larger loan than your current mortgage balance that includes a cash payment drawing on your home equity. For example, if you have $200,000 remaining on your mortgage and your home is worth $500,000, you could choose a cash-out refinance for $250,000 and get $50,000 in cash to pursue a home renovation or pay down debt. Lenders will likely limit you to borrowing up to 80% of your home's current value.

To Add or Remove a Borrower

Since refinancing results in a new home loan, it gives you the opportunity to alter the co-borrowers on the loan, either by adding someone new or removing an existing borrower. You may want to do this if you divorce and want to remove a spouse as a co-borrower—or if you get married and your spouse has good credit and income, which could qualify you for better terms on the loan when you refinance.

To Get Rid of PMI

If you have a conventional loan, you'll pay private mortgage insurance (PMI) if you put less than 20% down during the initial purchase. The lender will automatically end PMI payments when you reach 22% equity in your home. But you can often get rid of PMI once you reach 20% equity if you choose a traditional refinance (not a cash-out refinance).

When Not to Refinance Your Home

There are circumstances when refinancing may not be worth it, such as when you won't save a meaningful amount of money or you may move before the savings justify the cost. Here's when it could make sense to skip refinancing:

You Can't Get a Lower Interest Rate

You may not qualify for a lower interest rate if you have bad credit or if your score isn't high enough to get you a significantly lower rate than you already have. Economic trends also play a role. The Federal Reserve's monetary policy, inflation and economic growth can all affect whether mortgage rates rise or fall, and your existing rate may be lower than what's available at the time you want to refinance.

You Just Bought Your Home

Depending on your loan type, you may not be able to refinance if you only recently bought your home. If you have a conventional loan, you can generally refinance after 30 days. But some government-backed mortgages, like FHA loans, have programs that require you to wait a certain amount of time—seven months in the case of the FHA streamline refinance loan. Cash-out refinances also typically require you to wait 12 months before applying.

You Don't Plan to Stay in Your Home Long Enough

When you refinance your mortgage, any savings you receive from a lower interest rate could be offset by closing costs, which generally range from 2% to 6% of the loan amount. It may not be worth refinancing if you don't plan on living in the home long enough to recoup these costs in interest savings. Calculate your break-even point to make sure it's not so far in the future that your plans could be uncertain.

You Plan to Use the Cash for Discretionary Spending

A cash-out refinance lets you take out a loan, in cash, backed by your home equity in addition to refinancing your existing mortgage. But this can be a risk, since your home serves as collateral and your lender could foreclose on your home if you default on the loan. Using refinance funds to improve your financial position—such as consolidating credit card debt—may be worth this risk, while financing a vacation or wedding may not.

How Much Does It Cost to Refinance a Mortgage?

Refinancing a mortgage typically costs 2% to 6% of the loan amount. If you refinance a $400,000 loan, closing costs could range from $8,000 to $24,000. Closing costs cover a broad range of expenses, from origination and home appraisal fees to title services. Lenders that offer no-closing-cost refinance mortgages generally charge higher rates or wrap closing costs into the loan, making them more expensive overall.

How to Refinance Your Mortgage

If you decide to refinance your mortgage, follow these steps:

1. Review your credit. Before applying, check your credit report and FICO^® Score^Θ to determine if they're strong enough to qualify for a new home loan. You'll typically need a credit score of 620 or higher; borrowers with higher credit scores tend to secure lower interest rates.
2. Evaluate your equity. Generally, you'll need 20% home equity to qualify for a mortgage refinance. Put another way, the loan-to-value (LTV) ratio—a percentage representing the amount of your home loan compared to the home's appraised value—should be 80% or less.
3. Shop and compare loan rates and fees. The Consumer Financial Protection Bureau (CFPB) recommends getting three or more loan estimates when shopping for a mortgage. Reviewing several loan offers allows you to compare interest rates, repayment terms, fees and other benefits to find the best loan for you.
4. Compare savings and costs. Ensure that refinancing makes financial sense. For instance, if the loan would lower your payment by $200, but the closing costs are $10,000, it would take 50 months to break even. Refinancing may save you money if you plan on living in the home longer than that.
5. Submit your application. Once you've chosen a loan offer, gather any documents you'll need beforehand. Fill out an application online, or over the phone or in person if your lender provides these options and you want a loan officer to walk you through it.
6. Close the loan. Typically, you'll need to meet with your lender to finalize the closing, pay closing costs and fees and sign documents. Consult with your lender about closing payments on your existing loan so there are no missed payments that could damage your credit. You should receive a letter or email from your new lender detailing your new monthly due date, amount and payment instructions.

Frequently Asked Questions

The Bottom Line

The best time to refinance a mortgage is when you know you will qualify for an interest rate that will lead to savings, and when you'll stay in the home long enough to justify the closing costs. You may also decide to refinance to pursue a specific goal, such as adding or removing a co-borrower, that's connected to an event in your life like marriage or divorce. What's most important is to ensure that refinancing will be a positive move for you financially and personally.