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Should I refinance my mortgage?

May 1, 2023
8 min read

What we'll cover

What refinancing is and what it covers
Different types of refinancing
When you should consider refinancing

Are you wondering, "Should I refinance my mortgage?"

It's a worthy question. A mortgage refinance loan means a lender replaces your current mortgage with a new one. The new mortgage will typically offer better terms than your old mortgage.

If you're unsure whether a mortgage refinance is the right move for you, we have the answers. Let's explore when you should refinance your mortgage, types of mortgage loans, how much it costs to refinance and the advantages and disadvantages of refinancing. By the time you're done reading, you'll have a better idea of whether mortgage refinancing makes sense for your needs.

What is a mortgage refinance?

Let's dig into a deeper definition of how a mortgage refinance works. When you refinance your mortgage, you use your new loan to pay off the original. You'll pay off your new loan, which often carries a new principal and a new interest rate, so you end up with just one payment.

When you apply to refinance, your lender asks for information about your income, assets, current debt and credit score.

When should I refinance my mortgage?

When might you want to refinance your mortgage? You may want to consider doing so if you reduce your interest rate, switch from an adjustable-rate mortgage to a fixed-rate mortgage or shorten your loan term. Let's take a closer look at the reasons why you may want to refinance your mortgage.

Reduce your interest rate

Reducing your mortgage interest rate means you'll enjoy smaller mortgage payments and overall, more savings each month. Getting a lower interest rate may help save you money over the life of your loan.

Switch from an adjustable-rate mortgage to a fixed rate

Switching from an adjustable-rate mortgage (ARM) to a fixed rate can also save you money. An ARM is a mortgage that changes periodically based on the market. A fixed-rate mortgage keeps the same interest rate throughout the life of the loan.

How exactly does it work? A 5/1 ARM rate stays locked for the first five years, then resets every year after that. If the ARM rate is higher at the annual reset, your mortgage payment could go up. If it is lower, your payment may go down.

Shorten your mortgage term

When you get a new loan to replace your current mortgage, you may be able to get a shorter term on the mortgage. For example, you may refinance from a 30-year-mortgage to a 15-year mortgage. However, you'll have to be prepared for a higher monthly payment. Look at a calculator to find out whether you can afford the higher monthly payment or if it would be better to chip in extra every so often to a 30-year loan.

Another great reason to refinance your mortgage: You can get rid of private mortgage insurance (PMI), which is a type of insurance that you must pay for a conventional loan if you don't put 20% down on the loan. If your home's equity has increased and you can now reach 20% equity in your home, you can get rid of PMI.

When you refinance your mortgage, you use your new loan to pay off the original.

Types of mortgage loans

There are a few different types of mortgage refinance options available, including cash-out refinances, cash-in refinances, rate-and-term refinances and more.

Cash-out refinance: A cash-out refinance means you take out a new home loan for a larger amount than what you owe on your original loan. You then receive the difference in cash between the two amounts.
Cash-in refinance: A cash-in refinance means that you put money into your refinance instead of taking it out, which reduces your loan-to-value (LTV) ratio and increases the equity (the amount you owe) of your home.
Rate-and-term refinance: Rate-and-term refinances let you change the interest rates and loan terms of existing mortgages. A rate-and-term refinance can be a great option because it allows you to pursue more favorable terms with your lender.

Three mortgage refinance options and what they mean.
Type of refinance	Definition
Cash-out refinance	Take out a new home loan for a larger amount than what you owe on your original loan.
Cash-in refinance	Put money into your refinance instead of taking it out.
Rate-and-term refinance	The interest rates and loan terms of your existing mortgage changes.

There are other types of refinancing available as well; ask your lender for details about all your options.

How much does it cost to refinance a mortgage?

In general, you can expect to pay between 2% and 5% of the home loan in the form of closing costs. This means that at closing, you'll pay these costs. For example, let's say you qualify for a mortgage loan amount of $250,000. In this case, you'd pay closing costs between $5,000 and $12,500. Some lenders may also charge lender fees. However, when refinancing with Ally Home , there are no application, origination, processing or underwriting fees.

Calculate your refinance savings

Let's take a look at how much you might save if you refinance your loans. Let's say you initially receive a 30-year mortgage for $300,000 at 4%. If you keep this interest rate and loan for the full term, you’ll end up paying $215,608.52 in total interest over the life of your loan.

Let’s say you refinance the loan into a new, 30-year mortgage at an interest rate of 3.5%. If you kept the new loan for 30 years, you would pay $184,968.26 in total interest over the life of the new loan. You would save a total of $30,640.26 by refinancing. (But note that lenders may not allow you to refinance immediately after getting your initial loan. Learn more about how often you can refinance your mortgage .)

Use Ally's refinance calculator to help you decide whether or not you should refinance.

Advantages of refinancing

What are the advantages of refinancing?

Pay off your loans faster: Refinancing allows you to refinance into a new loan with a shorter term, such as going from a 30-year loan to a 15-year mortgage. Doing so allows you to build equity more quickly and pay off your home.
Spend less over time: Shortening the length of time you pay on your mortgage means you spend less in interest. You may save potentially thousands on interest payments.
Gives you more wiggle room in your budget: When you refinance to a lengthier loan term, you may open yourself up to savings in your budget, particularly when your monthly payment goes down. Refinancing with a lower interest rate means you can save more.
More predictability in payments: Refinancing to a fixed-rate mortgage (one that stays the same) from a variable-rate mortgage (one that changes) can help you know what to expect with your mortgage payment each month because it won't change.
Pay for expenses: A cash-out refinance can give you access to extra cash if you need to pay for some expenses like an addition to your home, a pool or more. In a cash-out refinance, you borrow more than you currently owe (as long as you have the right amount of equity in your home) and keep the difference.

Disadvantages of refinancing

What are the downsides? Let's take a quick look at the downsides of refinancing.

You might not break even: Breaking even means that the money you put toward your refinance makes sense financially. The closing costs could make it hard for you to recoup those expenses quickly. To calculate your break-even point, you divide your closing costs by the amount you save every month to figure out whether you can break even on the deal.
You may owe more money over time: If you refinance from a 15-year mortgage to a 30-year mortgage, you'll benefit from a lower payment. This may work to your advantage in your month-to-month budget but you will end up paying more in interest over time.
Reduce equity in your home: When you take out a cash-out refinance, you borrow against the equity in your home. In other words, it works like this: If you have $75,000 in equity in your home and take out $30,000 in a cash-out refinance, you'll have $45,000 left in home equity.

Is it worth it to refinance?

This really depends on what you want to achieve by refinancing. You’ll need to evaluate your financial goals to determine if and when refinancing is worth it . Your goals could include:

Obtaining a lower interest rate
Converting from an adjustable-rate mortgage to a fixed-rate one
Reducing the amount of your monthly mortgage payments
Paying off your home faster
Tapping into your home’s equity to finance something else
Consolidating debt

One of the most common reasons why people refinance is because they’re looking to land a lower interest rate. Things to consider before refinancing your mortgage could include:

The Federal Reserve has lowered the benchmark interest rate from what it was when you signed up for your original mortgage.
You have improved your credit score and could qualify for a better rate.
You’re switching from an ARM to a fixed-rate mortgage.

This is important because the higher your interest rate, the more you’re likely to pay for your home in the long run and the longer it will take for you to build equity in your home. Above all, your decision to refinance should depend on your personal situation and personal preferences.

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