Guide to Refinancing Your Mortgage: When It Makes Sense
Determine if refinancing your mortgage makes financial sense. Learn about break-even points, closing costs, and types of refinancing options available.
What Is Mortgage Refinancing
Refinancing replaces your current mortgage with a new one, ideally with better terms. The most common reasons to refinance are to get a lower interest rate, shorten the loan term, switch from an adjustable rate to a fixed rate, eliminate private mortgage insurance, or tap home equity through a cash-out refinance. The process is similar to getting your original mortgage — you apply, get approved, go through underwriting, and close on the new loan, which pays off the old one. Refinancing involves closing costs of 2 to 5 percent of the loan amount, so it only makes financial sense when the savings outweigh these costs.
Calculating Your Break-Even Point
The break-even point tells you how long it takes for your monthly savings to recoup the closing costs of refinancing. Divide your total closing costs by your monthly payment savings. For example, if refinancing costs $6,000 and saves you $200 per month, your break-even point is 30 months (2.5 years). If you plan to stay in the home longer than 30 months, refinancing makes financial sense. If you might move sooner, the upfront costs may not be recovered. This calculation is the single most important factor in the refinancing decision and should be done before you apply.
Types of Refinancing
Rate-and-term refinancing changes your interest rate, loan term, or both without borrowing additional money. This is the most straightforward type. Cash-out refinancing lets you borrow more than your current balance and receive the difference in cash — useful for home improvements, debt consolidation, or other large expenses. Streamline refinancing (available for FHA, VA, and USDA loans) offers a simplified process with reduced documentation and sometimes no appraisal. Cash-in refinancing involves bringing cash to closing to reduce your loan balance, which can help you qualify for a better rate or eliminate PMI.
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When Refinancing Does Not Make Sense
Refinancing is generally not worthwhile if the rate difference is less than 0.5 to 0.75 percentage points, if you are more than halfway through your loan term (since you have already paid most of the interest), if you plan to sell the home before reaching the break-even point, or if your credit score has dropped significantly since your original mortgage. Extending a 30-year loan by refinancing into another 30-year term resets your amortization clock, meaning you pay more total interest even if the rate is lower. If you have 20 years left on your current mortgage, consider refinancing into a 15- or 20-year term instead.
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Frequently Asked Questions
How much does it cost to refinance?
Refinancing closing costs typically range from 2 to 5 percent of the loan amount. On a $300,000 loan, expect $6,000 to $15,000 in fees including application fees, appraisal, title insurance, origination fees, and recording fees. Some lenders offer no-closing-cost refinancing, but the costs are usually rolled into a slightly higher interest rate. Always compare the total cost of both options over your expected time in the home.
Does refinancing hurt my credit score?
Refinancing typically causes a small, temporary dip in your credit score due to the hard credit inquiry and the new account lowering your average account age. The impact is usually 5 to 10 points and recovers within a few months. Shopping multiple lenders within a 14- to 45-day window counts as a single inquiry for scoring purposes.
Can I refinance with bad credit?
It is possible but more difficult and expensive. FHA streamline refinancing may be an option if you already have an FHA loan, as it has less stringent credit requirements. Conventional refinancing generally requires a credit score of 620 or higher. If your credit score has dropped, consider spending six to twelve months improving it before refinancing to qualify for better rates.