When is refinancing a mortgage worth it? Consider these 6 scenarios
Oct. 20, 2020
7 min read
What we'll cover
What to consider when thinking about refinancing
Takeaways to help guide your decision
When it make sense to refinance
Picture this: The camera zooms in on a couple sitting at their dining room table surrounded by paperwork, a computer, and calculator. It’s a common scene of two homeowners who are thinking about refinancing, but they’re confused by the entire thing – term lengths, interest rates, loan principles, etc.
Before yelling “Action!” on your refinance, you’ll want to make sure it makes sense financially and/or with your needs. Not every scenario does. Sometimes all you need is one take — your first mortgage — to get it right. Other times, you should have another go at it. So, how do you determine if refinancing is worth it?
Our guide will help you steal the scene when it comes to making a home refinancing decision, but first, here are some factors to think about beforehand.
Setting the scene: What to consider before a home refinance
Breaking down the basics of a mortgage refinance is a good place to start. Whether you should refinance depends on several factors, including:
The length of time you’ve owned your home
How long you plan to stay in your current home
Your breakeven point — the amount of time that’s needed for your interest savings to exceed your refi closing costs
The amount you initially borrowed
How much of your loan is outstanding
Expense of closing costs — appraisal, title search, application fees, and more, which can cost between 2% and 5% of your loan’s principal
Your current interest rate
Your current loan term
Your new loan conditions
Your credit history and score
Whether you’re looking to withdraw cash (aka equity) from your home
Your other refinance goals
And whether you’re considering a rate-and-term, a cash-out, or a cash-in refi (the three most common types of refinancing loans), a refinance calculator can help you make sense of it all. You can utilize it in the following scenarios to see whether refinancing is worth it from a financial perspective.
When to refinance your mortgage
Scenario 1: Obtaining a lower interest rate
Getting a mortgage with a better interest rate is one of the main reasons to consider refinancing. Reducing your interest rate lowers how much you pay in interest each month, as well as the total amount you pay for your home.
For example, let’s say you’ve lived in your house that’s worth $200,000 for five years and have built 25% equity in it. You have a 30-year fixed-rate mortgage with a 5.0% interest rate. If you refinance to a new loan with a 3.5% interest rate, you could save $176 a month, or over the life of the loan, more than $63,360. Use our mortgage calculator to see how your specific scenario plays out.
If you refinance to a loan with a lower interest rate and a shorter term (from a 30-year fixed-rate loan to a 15-year fixed-rate), it may not reduce the amount of your monthly payment (in some instances, it could even increase), but you’ll still pay less overall in interest over the life of your mortgage.
Our take: Interest rates are at near historic lows, which might mean the time is right for a refi. A good rule of thumb to follow is to refinance if you can secure a rate that’s at least 1% lower than your previous one. Doing so could mean serious savings.
Scenario 2: Reducing the total cost of your monthly mortgage payment
Refinancing to lower your interest rate can shrink your mortgage bill. But it’s not always possible to improve your rate. If a better interest rate isn’t an option, you can reduce your monthly costs by refinancing to a mortgage with a longer term than the repayment period that’s left on your current loan.
Our take: There’s a trade-off when refinancing to a longer loan term. Since you’re increasing your repayment period, you’ll pay more in interest over the life of your loan. But your monthly costs become more manageable, so it could be worth it if your budget is tight.
Scenario 3: Converting from an adjustable-rate mortgage to a fixed-rate one
Adjustable-rate mortgages (ARMs) can be an alluring option for home buyers because you can secure a lower introductory rate during the early years of owning your house. In exchange, your loan’s rate has the potential to increase after that initial period. If interest rates have gone up since purchasing your home, you’re likely looking at a higher rate when your ARM adjusts — putting an unexpected strain on your budget.
Our take: If interest rates start to inch upward, you may want to consider refinancing your ARM to a fixed-rate mortgage, which will offer consistent monthly payments. But if rates continue to fall, the periodic rate adjustments on an ARM mean decreasing rates — and smaller monthly mortgage payments — eliminating the need to refinance to take advantage of a rate drop.
When interest rates fall, you could have the opportunity to refinance your existing loan for another one that allows you to pay off your home faster without much change to your monthly payment. Reducing your loan term can also lower the total amount of interest you pay over time, but your ability to do so greatly depends on your financial capability and flexibility.
Our take: Math always counts when it comes to refinancing, but it’s particularly important in this scenario. For instance, with a $200,000 home loan at a 5.5% fixed rate for 30 years, your monthly mortgage payment costs you $1,136. A 15-year, fixed-rate mortgage with an interest rate of 3.5% would raise your payment to $1,430. That’s a difference of $294 a month, which might be out of reach. In your particular situation, you might experience less of an increase to your monthly costs.
Scenario 5: Using your home's equity to finance something else
If you’ve owned your home for a considerable amount of time or your home's value has increased since you first purchased it, you could tap into the equity you’ve built (the money you’ve already paid towards your house) by refinancing — aka, a cash-out refinance. And those funds could be used for things like:
Completing significant home repairs, like new windows or exterior siding
Making long-sought home renovations, like that sparkling new bathroom
Paying for yourself or someone else to go to school
Our take: Expenses such as these can sometimes be hard to save up for, and a cash-out refinance can provide the money you need. Some improvements will boost the value of your home, while others won’t. But you may want to do renovations for your own enjoyment — even if they aren’t dire or don’t increase your property value. If you tap your equity to pay for something non house-related, what matters is that you should feel like it’s worth it and you’re willing to add to the cost of your home in order to get it.
Scenario 6: Consolidating debt
A debt-consolidation refinance lets you refinance to a fixed-rate while pulling out equity to pay off outstanding non-mortgage debt. When used carefully, it can be a valuable tool to pay back a debt that sometimes seems impossible. For example, a typical credit card has an interest rate of anywhere from 13% to 25% while mortgage interest rates are typically less than 10%. So, converting this high-interest credit card debt into a lower-interest mortgage could offer significant savings.
Our take: Refinancing to consolidate your debt under a more manageable umbrella of a lower interest mortgage may finally give you the path toward living debt-free. But you should try to resist the temptation to spend again once the refinancing gives you that freedom.
In the end, a home refi is a decision that’s unique to your own circumstances. You may yell “Cut!” on your first mortgage because it’ll save you a lot on interest. Or you may be beyond your breakeven point, but need to consolidate debt or pull out cash to pay for other expenses. Our mortgage calculator can help you make sense whether take two on your home — a mortgage refinance — is an award-winning move for your situation.