When Refinancing Makes Sense
Break-even is the whole calculation, and the popular rule of thumb gets it wrong.
Refinancing replaces your existing mortgage with a new one. It can lower your rate, change your term, drop mortgage insurance, or convert an ARM to a fixed rate. Each of those costs money to arrange, and whether it is worth doing comes down to one calculation.
The break-even
Refinancing carries closing costs much like a purchase: origination, appraisal, title work, recording fees. Expect 2% to 5% of the loan amount.
Divide the total cost by your monthly saving. The result is how many months it takes to get your money back.
Spend $6,000 to save $200 a month and you break even at thirty months. Sell or refinance again before then and you lost money. Stay longer and you keep the saving.
The rule of thumb is unreliable
The old advice about refinancing whenever rates drop by one percent ignores loan size and closing costs. One percent on a $600,000 loan is a large monthly saving against a fixed cost. The same percentage on a $120,000 loan may never break even. Run your own numbers instead.
Resetting the term hides part of the cost
Refinancing a loan you have paid for eight years into a fresh 30-year term lowers your payment two ways: the lower rate, and the fact that you just stretched the remaining balance back out over three decades.
Your monthly saving looks larger than the rate justifies, and your total interest can rise even though the rate fell. If you want the lower rate without giving back the years you have paid, ask about a term matching your remaining years, or take the 30-year and keep paying the old amount so the extra reduces principal.
Reasons other than rate
Dropping mortgage insurance. If your home has appreciated and you now hold more than 20% equity, refinancing into a conventional loan without PMI can save money even at a similar rate. On an FHA loan where the insurance runs for the life of the loan, this is often the main reason to refinance.
Leaving an ARM. Moving to a fixed rate before a reset removes the uncertainty, which can be worth doing at a rate no better than your current one.
Shortening the term. Moving from a 30-year to a 15-year raises your payment and cuts total interest by a large margin. This is the opposite of the usual refinance, and worth considering if your income has grown.
Removing someone from the loan. After a divorce or a change in circumstances, a refinance is generally the only way to release a borrower from the obligation. Removing them from the deed does not remove them from the mortgage.
Cash-out refinancing
A cash-out refinance replaces your loan with a larger one and pays you the difference. It converts home equity into cash at mortgage rates, which are lower than card or personal loan rates.
Consider what you are doing before you use it to clear card debt. You are moving unsecured debt onto your house, where the consequence of not paying is foreclosure rather than collections. You are also stretching those balances across the remaining mortgage term, which can cost more in total interest even at a much lower rate. If the spending that created the balances continues, you end up with both the larger mortgage and the card balances again.
What lenders check
Refinancing is a full application. Expect a credit pull, income verification, an appraisal and underwriting. Your rate depends on the same inputs as a purchase loan, including your credit score and your loan-to-value ratio.
Two things catch people. A drop in income since the original loan can prevent approval even with a perfect payment record. And an appraisal below expectations changes your LTV, which can move you into worse pricing or trigger mortgage insurance you were trying to escape.
No-cost refinancing
Some lenders offer to cover closing costs in exchange for a higher rate, or roll the costs into the loan balance. Neither is free. The first pays for the costs through the rate for as long as you hold the loan; the second adds to what you owe and accrues interest.
These can still be the right choice when you lack cash for closing costs or expect to move before a paid-up-front option would break even. Ask for quotes both ways and compare the total cost over the period you expect to keep the loan.
This article is general information about how consumer finance products work in the United States. It is not financial, tax or legal advice and is not a recommendation of any specific product or provider. Rules and pricing vary by state and by institution.