When interest rates hit record lows during the pandemic, many homeowners rushed to refinance. In fact, borrowers who refinanced during the first half of 2021 managed to save an average of more than $2,800 per year and lower their interest rates by more than 1.2% on average, according to data from Freddie Mac.
Times have changed. Refinance rates have more than doubled since then, and are now in the 6% to 7% range. With that surge, does it still make sense to refinance? The decision should be based on your personal financial situation and whether or not it makes economic sense to replace your mortgage with a new home loan. If today's interest rates are higher than the interest rate on your current mortgage, it probably doesn't make sense.
Read on for everything you need to know about how refinancing works, how much it costs and what it might mean for your budget.
What is refinancing?
When you refinance your mortgage, you pay off your existing mortgage with a new home loan that comes with new rates and terms. If you secured your existing mortgage when interest rates were higher than they are today, refinancing at a lower rate can save you money on your monthly payment or allow you to pay off the loan faster (and sometimes both).
Reasons to consider refinancing
There are many good reasons to refinance when conditions are right. Some of the most common scenarios include:
- Reducing your monthly payments: Switching to a new loan with a lower interest rate or longer repayment term can reduce your monthly mortgage payment. The amount you'll save each month depends on the size of your mortgage and how much lower the new interest rate is compared to your previous loan. Most experts recommend refinancing if you can reduce your interest rate by 0.75%.
- Paying off your mortgage sooner: If your original mortgage was a 30-year loan, you could refinance to pay it off sooner. With a lower interest rate, you may be able to switch to a 15-year loan and still have a manageable monthly payment. Reducing the length of the mortgage also lowers the total amount of interest you'll pay over the life of the loan.
- Getting cash out of your home: With a cash-out refinance, you apply for a new loan that's larger than what you owe on your old loan -- and take the difference as a cash payment. Many homeowners use a cash-out refinance to pay for home improvements.
- Switching to a fixed-rate loan: If you have an adjustable-rate mortgage, switching to a fixed-rate loan could be a good move. Refinancing can help you reduce future risk, according to Jason Fink, a professor of finance at James Madison University in Harrisonburg, Virginia. Locking in a fixed rate provides both predictability and protection from future rate increases.
- Switching lenders: If you don't like your current lender, refinancing is one way of moving your business.
- Eliminating private mortgage insurance: Most loans require private mortgage insurance if you put less than 20% down when buying a home. As home prices have increased, you may have crossed the 20% equity threshold, creating an opportunity for you to refinance without PMI. (Note that you can also ask your current lender to eliminate the PMI without refinancing.)
Reasons to not refinance
- The fees are too high: While refinancing can save money in the long run, you'll need to pay upfront closing costs that can add up to thousands of dollars.
- Interest rates are higher: If the interest rates have increased and your repayment term is the same, your payments will increase and you won't save money.
- You're planning on moving soon: It could take a few years to recoup your refinance fees. If you expect to move in a few years, the trouble and expense of refinancing now might not make sense.
- You're nearly finished paying off your mortgage: Mortgages are designed so that your highest interest payments come during the early years. The longer you've had the mortgage, the more your monthly payment goes to paying off the principal. If you refinance later in the loan term, you'll revert to primarily paying interest instead of building equity.
Different types of refinancing
There are a few different flavors of refinancing. Here's a breakdown of some of the different ways to replace your current home loan:
- Rate-and-term refinance: A rate-and-term refinance replaces your mortgage with a new rate and/or term with one of two goals: save money or pay off the loan faster. For example, you might decide to refinance a 30-year mortgage with a 7.5% interest rate with a new 30-year mortgage with a 6.5% interest rate to reduce your interest charges. Or you might have 20 years left on a 30-year mortgage and opt to refinance to a 15-year mortgage -- ideally with a lower interest rate -- to accelerate your payoff timeline.
- Cash-out refinance: A cash-out refinance replaces your existing mortgage with a new loan that has a larger amount. The goal with a cash-out refinance is to tap into your home equity and borrow cash at a low rate to cover a major expense such as remodeling your kitchen or paying for college.
- FHA or VA streamline refinance: If you have a mortgage backed by the FHA or the VA, you may be able to qualify for a streamline refinance. This "streamlines" the process by eliminating some of the additional paperwork involved. VA streamline refinances are commonly known as a VA IRRRL, or Interest Rate Reduction Refinance Loan.
How to get the best refi rate
Getting the lowest refinance rate available is similar to getting the lowest rate possible on a new purchase loan: It starts with your personal finances. Evaluate your credit report at least 30 days before you apply for a refinance; and if there is any incorrect information, dispute it. Creditors have 30 days to confirm the accuracy of the information or remove it from your report. Removing inaccurate information can improve your credit score and possibly help you qualify for a lower interest rate.
Taking steps to improve your credit, including paying off credit cards, can lower the risk associated with your new loan. It's also important to compare options from multiple lenders. In addition to scoring the lowest rate, shopping around can help you find options with lower fees to help save on your closing costs.
How to apply to refinance my home loan
If the conditions are right for refinancing, here's a rundown of how to find the best deal.
1. Get your credit in great shape: While conventional lenders will approve refinance applications with a credit score of 620 or higher, the best rates go to borrowers with scores of 740 or higher.
2. Figure out how much home equity you have: How much is your house worth? And how much money do you still owe on your current mortgage? The difference is your home equity. Simply put, the higher equity, the better you'll look in the eyes of a lender.
3. Compare multiple offers: You don't have to refinance your mortgage with your current lender -- though it's worth starting with them to see what they can offer. Some lenders will waive certain fees for current borrowers who want to refinance. Make sure you compare other options, though. Comparison-shopping is the key to saving money, whether you're shopping for groceries or a new mortgage.
4. Lock your rate: Rates have been rising due to the Federal Reserve's work to fight inflation, so it's important to lock in a rate once you find one that suits your needs. If you don't, you could wind up paying more. Make sure you ask about a float-down rate lock, which lets you take advantage of lower interest rates if they become available.
5. Communicate: Once you settle on a lender, it's important to be responsive to requests for financial documentation. The faster you respond, the faster you'll be able to close on the new loan, and the faster you'll be able to start saving money with your lower rate.
Are refi rates different from purchase rates?
There may be a slight difference between average refinance rates and average rates for purchase loans. The bigger difference between buying a new home and refinancing your current mortgage tends to be with the closing costs. The closing costs for refinances are lower, averaging less than 1% of the total loan amount. There are some exceptions, however, in New York, Pennsylvania and Delaware, where closing costs are significantly higher.
How much does refinancing cost?
Refinancing involves paying closing costs, though the costs tend to be lower than with a new purchase loan. In 2021, the average closing costs to refinance a mortgage for a single-family home added up to $2,375, according to data from ClosingCorp. That figure does not include any local taxes, however, which can add thousands in certain parts of the country.
Is refinancing worth it?
To figure out if refinancing makes financial sense, you need to determine your break-even point: When your savings are greater than the costs associated with refinancing the loan. This ultimately comes down to how long you plan to live in the home. If you're going to pay $6,000 to refinance your mortgage for a lower rate, for example, you'll need to determine if you will be in the home long enough for the savings you'll receive each month to add up to more than $6,000.