Refinancing your mortgage can be a pretty sweet deal. You can lower your monthly payment, cut down the amount of time you need to pay or even pull out cash.
With rates at historic lows, millions of homeowners have already refinanced their mortgages this year. Currently, roughly another 18 million borrowers could potentially benefit from a new loan, according to real estate data firm Black Knight. But, just like taking out a purchase mortgage, refinancing requires time and money. You want to be certain it makes sense for you.
Here are four questions to determine if you should refinance—and one tempting query you should ignore:
Do ask: What do I want to accomplish?
Refinancing replaces your current mortgage with a new loan that has a new term, a new rate and a new monthly payment. By refinancing, you can lower your monthly payments, get a shorter loan term or take out cash—but you generally can’t do all three. You’ll need to figure out your goals and what tradeoffs you’re willing to make.
*Looking for more room in your monthly budget? You’ll need either the longest possible loan—typically 30-years—or the lowest possible interest rate. Rates tend to be lowest on adjustable-rate mortgages, but you risk seeing a big jump after the initial fixed period, so an ARM only makes sense if you will move in the next few years.
*Is getting out of debt as soon as possible a priority? Look for a loan with a shorter term than is left on your current mortgage. (Most lenders offer 15-year loans, but some, such as Quicken Loans, allow borrowers to choose periods as short as eight years.) Monthly payments on a shorter loan are higher, since you’re dividing the balance over a shorter period, but you’ll own your home outright sooner, your mortgage rate will be lower and you’ll pay less total interest over time.
*Need cash now? With a cash out refinance, you can pull out equity you’ve built in your home. You end up with a larger loan balance, but can put that money toward paying off higher interest debt or making renovations. Lenders generally require a borrower maintain at least 20% equity in the home and will charge a higher interest rate than for a no-cash refi.
Do ask: How much can I lower my rate?
Average rates on a 30-year fixed mortgage have been below 4% since June 2019 and crossed below 3% for the first time this summer. This means that millions of homeowners could save money by refinancing.
Keep in mind that you may be charged a higher rate than lenders are advertising, depending on your credit score and how much equity you currently have in your home. So go through the pre-approval process with at least three lenders to find out what your real rate may be and to make sure you are getting the best deal. Freddie Mac has found that borrowers save an average of $1,500 over the life of the loan by getting an additional rate quote and an average of about $3,000 if they get five quotes.
A popular rule of thumb says: If you can reduce your interest rate by full percentage point or more you should refinance. For a 30-year loan with a $400,000 balance, lowering your interest rate from 4% to 3% would reduce your monthly payment by about $220 per month. Though it can make sense to refi for less depending on your needs.
Do ask: Can I improve my application?
Whether you are purchasing a home or refinancing, three main inputs determine whether you’ll qualify for a mortgage and what rate you’ll be charged. They are your credit score, as well as your loan-to-value and debt-to-income ratios. If your financial picture has deteriorated significantly since you bought your home, either because of a job loss or new debt, it may be difficult to qualify for a new loan at all.
Check your credit score before shopping for a new loan. If your credit score has gone up since you took out your mortgage you will likely qualify for a better rate. If it is lower or the same, you may want to take some time to try improving your score before applying. Paying down debt and asking for credit line increases are all ways to boost your credit score. Checking your credit report and reporting any errors can also help. Typically borrowers need around a 740 credit score to qualify for the very best rates.
If you’ve lived in your home for a few years and have paid your mortgage consistently, you’ll have built up equity and need a smaller loan today relative to the value of your home—especially if your home is worth more today than when you bought it. You can think of your home equity like the down payment you made on your purchase mortgage. Having more equity, especially once you exceed the 20% threshold, gives you more options—and a better mortgage rate, because lenders will regard the loan as lower risk. Keep in mind that a larger portion of your payment goes toward interest in the early years of a loan, this process is called loan amortization.
(If you have an FHA loan, once you reach 20% equity, you may want to refinance to a conventional loan to eliminate mortgage insurance premiums, which typically run between $30 and $70 per month for every $100,000 borrowed. If you have a private loan you can request insurance premiums be dropped once your loan-to-value ratio, or LTV, reaches 80%.)
Increasing your income is unlikely to directly improve your mortgage rate, since you needed to have a debt to income ratio below about 45% to get a loan in the first place. Earning more, of course, is never a bad thing. You can use the additional money to pay down other debt, which will help with your credit score, or to more comfortably cover the payments on a shorter loan that will save you money in the long run and help you get out of debt sooner. If you want to grow your equity and have the means, you can pay more than you’re required monthly. Just make sure to specify that you want the additional money applied to your principal balance and confirm that your lender will not charge a prepayment penalty.
Do ask: How much does it cost to refinance a mortgage?
Refinancing, of course, is not free. The average closing costs to refinance are about $5,000, according to Freddie Mac. Where you live and the size of your loan, however, make a big difference in how much you’ll pay. In addition to origination fees—generally around 1% of the loan amount—you will need to pay appraisal, title and credit report fees, among others. Recently, Freddie Mac announced a new Adverse Market Refinance Fee, which the Mortgage Bankers Association estimates will cost the average homeowner an extra $1,400 starting in December.
Typically people pay these costs upfront. Making how long it will take to recoup your closing costs an important factor in whether it makes sense to refinance at all. To do the math for yourself, divide your closing costs by how much you would save each month by refinancing. If it will take you 48 months—4 years—to recoup the costs, but you only expect to stay in the house for three years it probably does not pay to refinance.
Your lender may offer what is called a no-cost refinance. Instead of paying these fees upfront, with a no-cost refi you pay over time, either by adding the balance to your loan principal or with a higher interest rate. (If you have a loan they cannot sell on the secondary market, like a jumbo mortgage, a no-cost refinance may not be an option for you.) A no-cost refi can be a good deal if you plan to sell relatively soon. However, you may end up paying more over the life of the loan by paying a higher rate or adding principal.
If this is your forever home, one final thing to keep in mind is that by refinancing to a loan term longer than you have left on your current mortgage you will be extending the overall time you’ll be paying for your house and in some cases end up paying more in total interest.
For instance, imagine that a decade ago you took out a $200,000 30-year fixed rate loan with a 4.187% mortgage rate. If you refinanced to the same loan type today with a 3.437% rate, you would save $121 a month. It will take about four years to recoup average closing costs. But after 20 years the original loan would have been paid off, while you will keep paying interest on the new one for another decade. All told, by spreading mortgage payments over 40 years instead of 30, you would end up paying about $80,000 more in interest than if you stayed in the original loan, despite the lower monthly payment. A refinance calculator can help you determine if that is the case for you.
Do not ask: Will mortgage rates keep dropping?
As with stocks, timing the mortgage market is generally not worth the trouble. “The odds are you will never buy a stock at the absolute low or sell it at the absolutely high,” says Patrick Boyaggi, chief executive of digital mortgage brokerage Own Up. “In the same way, the odds you will get the lowest interest rate ever for your particular situation is also low.”
In other words, don’t wait to see what happens with mortgage rates tomorrow, if you can save money or move closer to your financial goals by refinancing today.