When is the right time to refinance my mortgage?

When it comes to finding a way to reduce your mortgage costs, refinancing could be the answer — and plenty of homeowners agree. In 2020, Americans gave the mortgage industry about $2.6 trillion in refinance business — more than double the amount from 2019 — according to data from Freddie Mac.

Refinancing allows many homeowners to take advantage of low mortgage rates, lower their monthly payments and tap into their home equity. But even if rates are at an all-time low, it doesn’t always mean that refinancing is the right move for you.

Before you can decide when’s the right time to refinance your mortgage, you’ll need to consider a few factors.

• When to refinance your mortgage
• How does a mortgage refinance work?
• What are the different types of refinancing?
• Should I refinance my mortgage?
• When refinancing your mortgage might not make sense

When to refinance your mortgage

The right time to refinance a mortgage is different for everyone. Whether it’s the right decision for you depends on a few factors, such as your financial goals and how long you plan to stay in your home.

That said, there are some common factors that may be a sign refinancing is the right decision for you.

You want a lower interest rate

One of the most popular reasons why homeowners refinance is to lower their interest rate, which can save thousands of dollars over the life of the loan. If you took out a home loan when rates were high, you could be overpaying for your mortgage. Refinancing in this case could make sense.

You want to tap your home equity

Whether you want to pay off high-interest debt or make significant home renovations, you can tap into your home equity with a cash-out refinance (more on this below).

Assuming your new rate is less than your current one, a cash-out refinance could be a smart financial choice. But keep in mind that the best use of your home equity is usually to boost or preserve the value of your home with improvements or repairs. Cashing out equity to pay off other debts turns unsecured debts into one secured by your home.

You’re early into repaying your mortgage

When you first start paying down your mortgage, your monthly mortgage payments are going more toward the interest rather than your principal (the amount of money you originally borrowed). The longer you are into your loan term, the more of your monthly payments will go toward the principal. This shift is called amortization.

If you refinance now, before those payments start going toward your principal, you won’t have to start the amortization process again.

You want to change your loan type

If you currently have an adjustable-rate mortgage, or ARM, you likely received a lower rate at the beginning of the loan. But after a certain amount of time, the rate will reset and could increase — potentially by a lot. Refinancing into a fixed-rate mortgage to lock in a low rate might make sense.

You want to get rid of PMI

If you took out a conventional loan when you bought your home and your down payment was less than 20%, you’ve probably been paying private mortgage insurance, or PMI. This protects the lender — not you — if you fall behind on your mortgage payments.

One way to get rid of PMI is by refinancing — you may be able to do this if your home’s value has increased significantly since you bought it, and your loan-to-value ratio is less than 80%. In this case, refinancing to eliminate PMI could save you hundreds or thousands of dollars each year.

You want to pay off your loan sooner

If interest rates have fallen since you first took out your mortgage, refinancing your loan into a shorter term may be a smart idea, especially if you can comfortably make higher monthly payments. In most cases, loans with shorter terms tend to have lower interest rates, saving you money.

So, if you refinance your 20-year mortgage to a 15-year mortgage, you can pay off your loan five years sooner — and save yourself five years’ worth of interest.

How does a mortgage refinance work?

Refinancing your mortgage means you take out a new loan to pay off your existing one. Whether your new mortgage is from the same lender that holds your current mortgage, or from a different lender, it will have a different interest rate and term. You may even choose a different type of loan.

Just as when you took out your original mortgage, you’ll need to go through an application and approval process. You’ll also likely have to pay some closing costs as well.

How much does it cost to refinance?

Refinancing fees typically cost anywhere from 3% to 6% of your borrowed amount. Keep in mind that this doesn’t include any costs you may incur for paying off your existing mortgage, like a prepayment penalty.

While refinancing fees vary by lender and location, here’s a list of typical ones you’re most likely to pay:

• Application fee
• Origination fee
• Appraisal fee
• Closing or attorney fee
• Escrow (goes toward taxes and insurance)
• Fees related to loans insured by the FHA or VA
• Title search and insurance fees

What are the different types of refinancing?

Homeowners can choose from the following refinancing options:

• Rate-and-term refinance — With a rate-and-term refinance, you can change your interest rate, loan term or both. This enables you to save money on interest or secure a lower monthly payment. Your new loan amount will usually be equal to the remaining balance on your original mortgage, unless you decide to roll closing costs into your new mortgage.
• Cash-out refinance — This type of refinance also allows you to change your rate, term or both. But you borrow more than you need to pay off your current loan and pocket the difference as cash, which you can use for almost any purpose. You can only choose a cash-out refinance if you have enough equity built up in your home.
• Cash-in refinance — Instead of taking additional money out, a cash-in refinance allows you to make a lump sum payment on your existing mortgage to reduce the principal balance on your new mortgage. It's similar to a mortgage recast, where the lender agrees to change your loan terms when you make a lump sum payment.
• FHA streamline refinance — If you currently have an FHA loan, you may qualify for an FHA streamline refinance. The main benefit is that borrowers don’t have to complete as much paperwork as with a traditional refinance. But in order to qualify, you can’t be behind on your current mortgage, and you can’t cash out more than $500.

Should I refinance my mortgage?

When deciding whether to refinance your mortgage, figure out whether you want to spend the time and effort to do so. While refinancing is an individual decision, you can do some calculations to determine whether it’s worth paying closing costs for the chance to save money on a new mortgage.

How to calculate your break-even point

Calculating your break-even point helps you ensure a refinance makes financial sense for you once closing costs and other fees are factored in. The break-even point is the time it takes for your refinance to pay for itself, or break even. It makes the most sense to refinance if you stay in your home past this time.

To calculate the break-even point, take the overall mortgage costs for your new loan and divide it by the monthly savings you’ll receive. For example, if you need to pay $6,000 in closing costs but you’ll save $250 each month from refinancing, it’ll take you 24 months to reach the break-even point.

That means for refinancing to be worth it, you’ll want to stay in your home for more than 24 months.

When refinancing your mortgage might not make sense

The idea of lowering your mortgage costs through a refinance can be appealing. But it’s not always the right decision for everyone. Here are a few scenarios when refinancing may not be a smart idea:

• You have a prepayment penalty. If you need to pay a prepayment penalty to pay off your current mortgage early, factor that fee into your closing costs to see whether it’s worth it. Ask your current lender how much the prepayment penalty would be. In some cases, you may be able to negotiate a penalty waiver if you refinance your mortgage with the same lender.
• You have an existing home equity loan. If you have a home equity loan or home equity line of credit (HELOC), ask your lender if you’re eligible to refinance. If not, you’ll have to pay off the amount you owe on your home equity loan before getting a new mortgage.
• You’re moving soon. If you plan on moving in less than a year, you may not be able to reach your break-even point, so a refinance probably wouldn’t be worth it in this situation.