When to Consider Refinancing and How to Know If It’s Worth It
If you’re a homeowner, you’ve probably heard that refinancing your mortgage could help you save money. But how do you know when it’s the right time to refinance, and whether the potential savings are worth the cost?
Refinancing can be a useful financial tool, whether you’re hoping to lower your monthly mortgage payment, pay off your home sooner or access some of the equity you’ve built. Before making a decision, it’s important to understand how refinancing works and what it could mean for your finances.
What Does It Mean to Refinance Your Mortgage?
Refinancing means replacing your existing mortgage with a new loan, typically with different terms, an updated interest rate or a new repayment schedule.
When you refinance, your new mortgage pays off your existing loan, and you begin making payments under the new loan agreement.
Depending on your financial situation and goals, refinancing could help you reduce your monthly payments, save on interest over time or make changes to your mortgage that better fit your needs.
However, refinancing comes with costs, so it’s important to weigh the potential benefits before moving forward.
When Should You Consider Refinancing?
There are several situations where refinancing may be worth exploring.
1. Mortgage Interest Rates Have Dropped
One of the most common reasons homeowners refinance is to take advantage of lower mortgage interest rates.
If current rates are lower than the rate on your existing mortgage, refinancing could reduce your monthly principal and interest payment. Depending on your loan balance and repayment term, it could also save you money in interest over time.
However, a lower interest rate doesn’t automatically mean refinancing is the best financial decision. You’ll also need to consider the cost of obtaining the new loan and how long you plan to stay in your home.
2. You Want to Pay Off Your Mortgage Sooner
If your financial situation has improved since purchasing your home, refinancing into a shorter loan term may help you pay off your mortgage faster.
For example, switching from a 30-year mortgage to a 15-year mortgage could help you build equity faster and reduce the total interest you pay.
Keep in mind that shortening your loan term will typically increase your monthly payment, even if you qualify for a lower interest rate. Make sure the new payment fits comfortably within your budget.
3. You Want More Predictable Monthly Payments
If you currently have an adjustable-rate mortgage (ARM), you can consider refinancing into a fixed-rate mortgage.
An ARM typically starts with an interest rate that remains fixed for a certain period before adjusting based on market conditions. This means your monthly mortgage payment could increase or decrease over time.
Refinancing into a fixed-rate mortgage can provide more predictable principal and interest payments, making it easier to plan your household budget.
4. You Want to Access Your Home Equity
As you pay down your mortgage and your home’s value changes, you may build equity, which is the difference between what your home is worth and what you owe on your mortgage.
A cash-out refinance allows you to replace your existing mortgage with a larger loan and receive a portion of the difference in cash.
Some homeowners use these funds for major home improvements or other financial needs.
However, borrowing against your home equity increases the amount you owe and may extend your repayment timeline. Carefully consider how you’ll use the funds and whether taking on additional mortgage debt makes sense for your financial situation.
How Do You Know If Refinancing Is Worth It?
Before refinancing, it’s important to look at the numbers.
According to Freddie Mac, refinancing costs can range from approximately 3% to 6% of your loan principal, depending on factors such as your lender, credit score and location.
These expenses may include lender fees, appraisal costs, title-related fees and other closing costs.
One way to determine whether refinancing makes financial sense is to calculate your break-even point, or how long it will take for your monthly savings to cover the cost of refinancing.
How to Calculate Your Break-Even Point
Let’s say you’re considering refinancing your mortgage with the following estimates:
- Total refinancing costs: $4,500
- Monthly savings: $150
Divide the total refinancing costs by your monthly savings:
$4,500 ÷ $150 = 30 months
In this example, it would take approximately two and a half years to recover the upfront costs of refinancing.
If you plan to remain in your home for several years beyond that point, refinancing may be financially beneficial.
However, if you’re planning to sell your home in the next year or two, you may not have enough time to recover those costs.
This calculation is most useful when refinancing primarily to lower your monthly payment. If you’re shortening your loan term or taking cash out, you’ll need to evaluate the financial benefits differently.
You can also use Freddie Mac’s Refinance Calculator to help evaluate your options.
What Else Should You Consider Before Refinancing?
Beyond interest rates and monthly savings, there are several other factors that can influence your decision.
Your credit score: Just like when you applied for your original mortgage, lenders will review your credit history when evaluating your refinance application. A stronger credit profile may help you qualify for more favorable loan terms.
Your home equity: The amount of equity you have in your home can affect your refinancing options. Depending on your loan program and equity, you may also need to pay private mortgage insurance (PMI).
Your remaining loan term: If you’ve already paid several years toward your mortgage, refinancing into a new 30-year loan could extend the time it takes to pay off your home. Even with a lower monthly payment, you could end up paying more interest overall.
Your future plans: Think about how long you expect to stay in your current home. If you’re considering selling or moving in the near future, the upfront costs of refinancing may outweigh the potential savings.
Your total housing expenses: Refinancing may change your principal and interest payment, but you’ll still need to account for property taxes, homeowners insurance and other homeownership expenses. In Chicago, changes in property taxes can affect your total monthly housing payment regardless of your mortgage interest rate.
Tips Before Moving Forward With a Refinance
If you’re considering refinancing, take time to compare your options before committing to a new loan.
- Shop around with multiple lenders. You don’t have to refinance through your current mortgage lender. Comparing loan estimates from different lenders can help you identify competitive interest rates, fees and terms.
- Ask about all closing costs. Some lenders advertise refinancing options with little or no upfront closing costs. However, those expenses may be added to your loan balance or reflected in a higher interest rate.
- Compare the total cost of your loans. Look beyond your new monthly payment. Consider the interest you’ll pay over the remaining life of your current mortgage compared with the proposed new loan.
- Understand your financial goals. Whether your priority is reducing monthly expenses or paying off your mortgage sooner, make sure your refinancing decision supports your long-term plans.
Make the Decision That’s Right for You
Refinancing can offer valuable financial benefits, but the right time to refinance depends on your individual circumstances.
Before making a decision, consider your current mortgage terms, the costs of refinancing and how long you plan to remain in your home. A trusted mortgage lender or housing counselor can help you evaluate your options and understand the potential financial impact.
And if refinancing is part of a larger decision about whether to stay in your current home or purchase a new one, connect with a local REALTOR® who can help you understand Chicago’s housing market and make an informed decision about your next steps.
Homeownership is a long-term investment. Taking the time to evaluate your mortgage options can help you make financial decisions that support your goals for years to come.
