Mortgage refinancing is often thought of as a way to lower your monthly payment when interest rates drop. While that is certainly one form of refinancing, it isn’t the only reason you might want to refinance your mortgage. In fact, in some cases mortgage refinancing could make sense even if prevailing interest rates are higher than when you obtained your mortgage.
With that in mind, let’s take a closer look at mortgage refinancing and whether it could make sense for you. In this article, we’ll discuss five of the most common reasons to refinance a mortgage and how to tell if you should consider it.
You want to take advantage of lower interest rates
As we already mentioned, one of the most common mortgage refinancing reasons is to lower your interest rate. For example, mortgage interest rates hit all-time lows in 2020 and 2021, and as a result, there was a massive surge in mortgage refinancing volume.
Even if mortgage refinancing rates don’t fall back towards all-time lows, you might be surprised at how much you could save by refinancing even if they fall a seemingly small amount. For example, a $400,000 mortgage with a 30-year fixed-rate term would have a $2,661 monthly principal and interest (P+I) payment at a 7% interest rate. If rates drop to 6%, completing a mortgage refinancing could drop your monthly payment to $2,398, a savings of $263 per month or $3,156 per year.
Of course, it’s important to realize that mortgage refinancing isn’t free. For this and all of the other reasons to refinance a mortgage that we’ll discuss here, you need to make sure the benefits of refinancing justify the cost. In the previous example, even if you have to pay $5,000 in closing costs to refinance, you’d break even in less than two years with the savings on your monthly payment.
Your credit score has improved
Here’s a situation where mortgage refinancing could make sense even if prevailing interest rates have risen.
Even if market interest rates haven’t improved, it can still be worth looking into mortgage refinancing if your credit score has improved significantly. On a conventional mortgage loan, you might be surprised at how much your credit score can help you get a better interest rate.
While the data will almost certainly have changed by the time you’re reading this, consider this example. As of August 2023, a borrower with a 760 credit score (considered to be excellent credit) could expect a 6.97% APR on a 30-year mortgage, according to data from myFICO.com. On the other hand, a borrower with a score of 650 (below average, considered fair credit) could expect a rate of 8.01%.
On a $500,000 mortgage loan, this difference in interest rates translates to a $357 difference in monthly payments. Depending on your circumstances, it could certainly be worth refinancing if your credit score has improved substantially since you first obtained your mortgage.
You want to drop mortgage insurance
In most cases, if you put less than 20% down when you bought your home, you’ll have to pay mortgage insurance. And if you used an FHA loan to buy your home, you’ll typically have to pay mortgage insurance for the entire term of the loan.
However, if you now have a loan-to-value ratio of 80% or less, meaning that your mortgage balance is less than 80% of your home’s market value, mortgage refinancing might allow you to drop your mortgage insurance completely. Since the average home price in the United States has increased by nearly 30% since 2020, it’s fair to say that many homeowners could potentially drop mortgage insurance by refinancing.
You want to extend your term and lower payments
Let’s say that 10 years ago, you obtained a $400,000 mortgage loan with a 30-year term and a 6% interest rate. On this loan, your monthly principal and interest payment is $2,398. You still owe about $337,000 on the loan and have another 20 years of payments to go.
If your goal is to lower your monthly payments, you can refinance your mortgage into a new 30-year loan and effectively spread the remaining balance over a new 30-year term. If you can get a mortgage refinancing loan with a 6% interest rate, your $337,000 balance would reduce your payment to $2,020 when stretched over a new 30-year term.
To be sure, if you refinance to extend your term, you’ll likely pay significantly more interest over the term of the loan. However, if your priority is keeping your monthly expenses as low as possible, mortgage refinancing into a new 30-year term can be worth a look.
You want to tap into your equity
Last, but certainly not least, another common reason for mortgage refinancing is to access your home’s equity. The average home value in the United States has risen about 33% in the past three years, so there are many homeowners with equity that could potentially be accessed. Known as a cash-out refinance, this type of mortgage refinancing loan involves obtaining a new mortgage with a higher principal balance than your current loan and receiving a check at closing for the difference.
Here’s an example of how this type of mortgage refinancing could work. Let’s say that your house has an appraised value of $600,000 and you have a $250,000 remaining balance on your mortgage. You could obtain a new loan for $400,000 and receive $150,000 at closing, less any fees and other closing costs.
There are a few caveats to keep in mind. For one thing, most lenders use a maximum loan-to-value (LTV) ratio of 80% when it comes to cash-out refinancing. In other words, if your home is worth $500,000, the maximum loan you’re likely to get would be for $400,000.
Second, unless you get a much lower interest rate on your cash-out mortgage refinancing than your current loan, your monthly payments are likely to be significantly higher after you obtain the new loan. So, be sure you can handle the new payment amount before you commit.
However, if you need to borrow money for home renovations or another large expense, using a cash-out refinance can be a smart way to finance it. Even in a high-rate environment, you’re likely to get a better interest rate from mortgage refinancing than you would from a personal loan or credit card.
Finally, it’s also worth mentioning that you don’t necessarily need to refinance your entire loan in order to tap into your equity. In many cases, such as if you have a very low interest rate on your current mortgage, a home equity loan or home equity line of credit (HELOC) could be a smarter way to go. Home equity loans and HELOCs are also known as second mortgages, as you keep your current loan and obtain a separate loan backed by your home to access your equity.
Is refinancing worth it for you?
As mentioned, mortgage refinancing isn’t free. You’ll likely pay an origination fee to your lender and several other closing costs when you refinance. Depending on the type of mortgage refinancing loan and your circumstances, you can expect to pay anywhere from 1%-3% of the loan amount in closing expenses when you refinance.
To be sure, mortgage refinancing can certainly be worthwhile. But it’s important to take a look at the costs versus the benefits to see if refinancing makes good financial sense for you.