Is Refinancing My Mortgage a Good Idea?

Whether refinancing your home is a good idea depends on many factors, including current interest rates, the length of time you plan to live there, and how long it will take to recoup your closing costs. In some cases, refinancing is a wise decision. In others, it may not be worth it.

Refinancing is generally easier than securing a loan as a first-time buyer because you already own the property. If you have owned your property or house for a long time and built up significant equity, refinancing will be even easier. However, refinancing can lead to a longer loan or more interest, depending on on the terms of your new loan and current interest rates.

Reasons to Refinance

So when is refinancing your mortgage a good idea? One rule of thumb is that refinancing may be a good idea when you can reduce your current interest rate by 1% or more. That's because you can save money in the long-term. Refinancing to a lower interest rate also allows you to build equity in your home more quickly.

If interest rates have dropped or if you can qualify for a lower rate, you can potentially also refinance to shorten the loan term without changing the monthly payment. For example, you may want to refinance from a 30-year to a 15-year fixed-rate mortgage.

Similarly, lower interest rates could be a reason to convert from a fixed-rate to an adjustable-rate mortgage (ARM), as periodic adjustments on an ARM should mean lower rates and smaller monthly payments.

During times when mortgage rates are rising, this strategy makes less financial sense. Indeed, the periodic ARM adjustments that increase the interest rate on your mortgage may make refinancing to a fixed-rate loan a good choice.

Consider Closing Costs

Closing costs from refinancing affect the savings you could get, so you'll need to calculate whether getting a new loan would cost you more than it would save you.

You will need to cover charges for title insurance, attorney’s fees, an appraisal, taxes, and transfer fees, among others. These refinancing costs, which can be between 3% and 6% of the loan’s principal, are almost as high as the cost of an initial mortgage and can take years to recoup.

If you are trying to reduce your monthly payments, beware of “no-closing-cost” refinancings from lenders. Although there may be no closing costs, a bank likely will recoup those fees by giving you a higher interest rate, which would defeat your goal.

Consider How Long You Plan to Stay in Your Home

In deciding whether or not to refinance, you’ll want to calculate what your monthly savings will be when the refinance is complete. Let’s say, for example, that you have a 30-year mortgage loan for $200,000. When you first assumed the loan, your interest rate was fixed at 6.5%, and your monthly payment was $1,257. If interest rates fall to 5.5% fixed, this could reduce your monthly payment to $1,130—a savings of $127 per month, or $1,524 annually.

Your lender can calculate your total closing costs for the refinance should you decide to proceed. If your costs amount to approximately $2,300, you can divide that figure by your savings to determine your break-even point—in this case, the home for two years or longer, refinancing would make sense one-and-a-half years in the home [$2,300 ÷ $1,524 = 1.5]. If you plan to stay in the home for two years or longer, refinancing would make sense.

If you want to refinance with less than a 1% reduction, say 0.5%, the picture changes. Using the same example, your monthly payment would be reduced to $1,194, a savings of $63 per month, or $756 annually [$2,300 ÷ $756 = 3.0], so you would have to stay in the home for three years. If your closing costs were higher, say $4,000, that period would jump to nearly five-and-a-half years.

Consider Private Mortgage Insurance (PMI)

During periods when home values decline, many homes are appraised for much less than they had been appraised in the past. If this is the case when you are considering refinancing, the lower valuation of your home may mean that you now lack sufficient equity to satisfy a 20% down payment on the new mortgage.

To refinance, you will be required to provide a larger cash deposit than you had expected, or you may need to carry PMI, which will ultimately increase your monthly payment. It could mean that, even with a drop in interest rates, your real savings might not amount to much.

Conversely, a refinance that will remove your PMI would save you money and might be worth doing for that reason alone. If your house has 20% or more equity, you will not need to pay PMI unless you have an FHA mortgage loan or you are considered a high-risk borrower.

The Bottom Line

Whether it's a good idea to refinance your mortgage will often depend on whether you can get a lower interest rate to save money. But many other factors play a role in whether refinancing will be in your best interest, including whether you can get lower monthly payment amounts and whether you can qualify for a new mortgage. Consider consulting a financial advisor to guide you through your options.