Is it Time for a Mortgage Refinance?
A mortgage refinance allows you to trade your current mortgage in for a new one. But does refinancing make sense today?
August 15, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
Over 65% of Americans own their own home — but the majority of homeowners still have mortgage debt. While mortgages allow easier access to homeownership, they also present significant costs for Americans — particularly if the interest rate is high.
One option that many homeowners consider is a mortgage refinance. Refinancing allows you to take out a new mortgage with new terms and rates. But does a mortgage refinance make sense?
What is a mortgage refinance?
Put simply, refinancing means that you are trading in your old mortgage for a new one. The new loan is used to pay off the old mortgage, leaving you with one monthly payment towards the new mortgage.
Refinancing can be done with any lender — it does not have to be the same lender that issued your original mortgage. The process of refinancing involves applying for a new loan, so you can expect significant paperwork. It often takes 30 to 45 days or more to refinance.
Why do people refinance their mortgage?
Refinancing involves upfront costs, so it only makes sense when there is a benefit to completing the refinance. Some people may even refinance their mortgage multiple times if it makes financial sense. The most common reasons for refinancing are described below.
To get a lower interest rate
The interest rate on a mortgage dramatically affects your monthly payment and total costs. So, any time you have the opportunity to refinance to a lower interest rate, it’s well worth considering.
You may be able to get a lower interest rate if rates have dropped since you applied, or perhaps if your credit score has improved significantly.
To change the loan term
Some borrowers may wish to shorten or extend their loan term, which will change the monthly payment amount.
For instance, refinancing a 30-year mortgage into a 15-year mortgage would result in a higher monthly payment, but potentially lower interest rates and a lower overall cost of financing. Refinancing from a 15-year to a 30-year loan would lower the monthly payment amount.
To convert mortgage type
Mortgages can have fixed or adjustable interest rates. In some cases, it may make sense to refinance in order to convert the mortgage into a type that’s more beneficial for your situation.
For example, a borrower with an adjustable rate mortgage (ARM) may want to lock into a fixed rate while interest rates are low.
To cash out on equity
A so-called “cash out refinance” allows you to tap into some of the equity you have built up in your home. You borrow more than you owe on your home and receive the difference to spend as you like.
Some homeowners may tap into their home equity to fund a major renovation or to consolidate debt. Because mortgage rates are typically lower than other loan types, this can be an affordable way to finance other expenses — but be warned that there may be tax implications. For example, for the interest to be tax deductible, the funds must be used for a substantial home improvement. The IRS defines substantial improvements as those that add to the value of your home, prolong your home's useful life, or adapt your home to new uses.
Pros and cons of a mortgage refinance
There are both advantages and disadvantages to consider when refinancing your home.
Can potentially lower your interest rate.
Can potentially lower your monthly payment.
Can be used to unlock equity in your home for other expenses.
Allows you to take advantage of a new loan with new terms.
The benefits of a refinance depend on your specific situation, current interest rates and what type of loan you plan to refinance to.
Closing costs can be costly.
Involves a substantial amount of paperwork.
May reduce the equity in your home (for cash-out refinances), which can lengthen the amount of time required to pay off your home.
A shorter-term loan may increase your monthly payment.
The biggest downside to consider is the effect of closing costs, which often run between 2% and 3% of the mortgage amount. That’s $6,000 to $9,000 on a $300,000 loan. In some cases, this cost can eliminate the benefit you may receive from refinancing. It’s important to try to quantify the benefits you will receive and compare these to the costs and effort involved with refinancing.
How to start a mortgage refinance
Refinancing a mortgage is similar to applying for a new mortgage. You will have to go through many of the same steps and procedures.
You will need your income information, credit information and tax returns or pay stubs. A real estate appraisal or inspection may be necessary, as well.
Here’s a step-by-step guide to how to refinance a mortgage.
1. Consider your goals. Are you hoping to refinance to a lower interest rate, or shorten the loan term to pay off your mortgage faster? It’s important to know what your goals are ahead of time so that you can shop for the right type of refinance.
2. Shop around for rates. Each lender will offer different rates, so it’s important to shop around. Even a small difference in interest rates can make a large difference over the course of the loan.
3. Consider the impact of fees. While shopping around, take note of the details relating to closing costs and other fees. Run the numbers to ensure that you’ll still benefit financially from refinancing, even after paying closing costs.
4. Apply with several lenders. You can shop around for estimated rates, but you will need to actually apply in order to receive a written offer. It’s best to apply with 3 to 5 lenders. To minimize the effect on your credit score, it’s wise to apply for all the loans within a 14-day period.
5. Lock the interest rate. Once you have applied and selected the right lender for you, you can typically “lock” the interest rate for a period of time. This allows you to continue closing on the loan, while locking in the agreed upon interest rate immediately.
6. Close on the new loan. All that’s left to do is continue the process to close on the loan and pay the closing costs. Now you’ll begin making payments towards your new mortgage.
Ultimately, a mortgage refinance makes sense if the benefits outweigh the costs. Just be sure to calculate the total closing costs and other fees, and compare this to the benefit you can receive from refinancing.
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