Factors to Consider Before You Refinance Your Mortgage

Refinancing a mortgage is typically done when someone wants to take advantage of lower interest rates or to change the repayment term of their mortgage. Usually, a person will refinance a mortgage to save on their monthly payments. Since mortgages are personalized products, there are no hard and fast rules about the best time to refinance. This is why it’s important to consider factors like your credit score, the current interest rate, and how much equity you have before you refinance your loan.

Key Takeaways

• Refinancing your mortgage can result in lower monthly payments, but you’ll have to pay hefty fees to refinance the loan.
• Most lenders require you to have at least 20% equity in your home to refinance your mortgage.
• Whether or not it makes sense to refinance depends on your financial situation and the terms of the new loan you’re offered.

Pros and Cons of Refinancing Your Mortgage

It’s easy to highlight the benefits of refinancing since it has the potential to save you a lot of money. However, there are some drawbacks that may come with changing the terms of your loan.

Pros

• You could pay less in interest on the loan

• Your monthly premium can be lower

• You can get a shorter term

• You can avoid private mortgage insurance (PMI)

• You can change mortgage products

• You can cash out some of your equity

Cons

• You’ll have to pay closing costs again

• It takes time to research lenders and loans

• Your credit score will likely take a hit

• You might take on more debt or have a higher monthly payment

Pros Explained

• You could pay less in interest on the loan: If you refinance at a lower interest rate, the total amount of interest you’ll pay over the life of the mortgage could be significantly lower.
• Your monthly premium can be lower: If interest rates have dropped since you took out your original mortgage, you can refinance and save money on your monthly payment. By putting that savings toward the loan’s principal, you might be able to pay off your mortgage faster.
• You can get a shorter term: Since you’re getting a new mortgage, you might choose a loan with a shorter term, as this will allow you to save on interest in the long run.
• You can avoid private mortgage insurance (PMI): If you hold at least 20% equity in your home when you refinance, you can avoid paying for PMI.
• You can change mortgage products: You might decide you’d prefer a different type of loan, such as an adjustable-rate mortgage (ARM). Refinancing gives you options.
• You can cash out some of your equity: Depending on how much equity you have, you can get a cash-out refinance and take out a larger loan. By paying off your current mortgage with the funds, you’ll still have money left over for other things like paying down debt, education expenses, or medical bills.

Cons Explained

• You’ll have to pay closing costs again: You can expect to pay 3% to 6% of the loan’s balance in closing costs. These cover things like appraisals, origination fees, recording costs, underwriting, and title services.
• It takes time to research lenders and loans: You’ll need to thoroughly investigate refinance lenders and loan options in order to find the most advantageous one for you, which could take more time than you want to spend.
• Your credit score will likely take a hit: To issue the new mortgage, your lender will make a hard inquiry, which can cause your score to drop. Although the effect on your score would only last a few months, the hard inquiry will stay on your report for two years.
• You might take on more debt or have a higher monthly payment: If you opt for a loan with a longer term length or take out a larger amount, you could end up paying considerably more each month than you are now.

Factors to Consider Before You Refinance Your Mortgage

Property Value and Your Equity

To find out if you’re even eligible to refinance, you need to find out what your home is currently valued at and how much equity you have in the property. Equity is basically the percentage of your home that you own.

To determine your equity, take your home’s current property value and subtract your current loan balance. Then, to determine your equity as a percentage, divide how much equity you have by the home’s value, and then multiply by 100.

Generally, lenders ask that you have at least 20% home equity before refinancing. Be aware that if your home’s property value has dropped, you may have negative equity. In this case, refinancing wouldn’t benefit you.

Example

If your home is valued at $300,000 and you currently owe $225,000, you would subtract what you owe to find the equity. Since $300,000 – $225,000 = $75,000, you would have $75,000 in equity.

To express this as a percentage, divide the equity by the home’s value. Since 75,000/300,000 = 0.25, you multiply the result by 100 to get 25%.

Your Credit Score

Pull up your credit score to see if it’s the same or improved since you took out your mortgage. Lenders look at your credit score to determine whether they’ll issue you credit and, if so, what interest rate to offer you.

The higher your credit score, the more favorable your interest rates will be. If your credit score has deteriorated since you took out your mortgage, the refinance lender might not offer you better terms. Instead, you may want to improve your credit score before refinancing down the road.

Your Debt-to-Income Ratio

In addition to looking at your credit score, lenders check your debt-to-income (DTI) ratio. This is how much debt you have in comparison to your income. Most lenders want to see low DTI ratios—ideally 36% or less—although some lenders might be willing to go up to 43%.

Calculating DTI Ratio

To figure out your DTI ratio, divide your total monthly debt payments by your gross monthly income. For example, if your mortgage payment is $1,500 and you also have another $1,000 worth of monthly payments that go toward your car and other debt, that adds up to a monthly debt payment of $2,500. If your gross monthly income is $7,500, you would divide $2,500 by $7,500, which comes out to a DTI of 33%.

The Costs of Refinancing

Refinancing isn’t free. There are closing costs, which could cost you between 3% and 6% of the total loan amount. These usually include origination fees, appraisal fees, title services, underwriting, and more.

Some lenders might offer to roll these fees into the loan, but that just means your loan will be that much larger. Others offer a “no-cost” refinance, which usually comes with higher interest rates to offset the cost to the creditor.

If you roll fees into the loan, be careful that doing so doesn’t push your loan-to-value (LTV) ratio to greater than 80% or else you’ll need to pay private mortgage insurance (PMI), which would add yet another cost.

Introductory Rates

If you have an ARM, pay close attention to what interest rate you’re currently paying compared to what you’ll pay after refinancing. You might be able to refinance to another ARM or a fixed-rate loan at a lower interest rate, but that’s not guaranteed.

You should also decide if you’ll pay refinancing points to reduce your loan’s interest rate. The cost of each point is equal to 1% of the loan amount. If you do choose to use refinancing points, be sure to factor this into the overall cost of refinancing.

Consider how long you have left on your current mortgage term. When you refinance, your term essentially restarts. So, if you’re close to paying off your mortgage, you might want to refinance with a shorter term so you can quickly pay off the new loan.

Your Current Lender

While it’s always a good idea to shop around for lenders, it might pay off to try and reach a new agreement with your current lender. After all, they probably don’t want to lose your monthly payment, so they may be willing to renegotiate your mortgage’s interest rate and/or term length.

This can be a particularly effective move if your credit score or DTI ratio has improved, as you can prove that you qualify for better interest rates with other lenders.

Your Breakeven Point

A major reason to refinance your mortgage is to save money on your payments. If refinancing won’t save you money, there’s likely no reason for you to go through the hassle. To help you figure out whether you’re actually saving, you need to determine your breakeven point. This is when the costs of refinancing your mortgage equals the savings you’d get from doing so.

To find your breakeven point, calculate all of your refinancing costs. Next, determine how much money you’d save each month with your refinanced loan. Then, divide the total cost of refinancing by the amount of money you’d save every month. The result is the number of months it will take you to breakeven after refinancing.

Your Taxes

As a homeowner, you might have enjoyed a heavy tax deduction by claiming your mortgage interest. If you always rely on this deduction to reduce your taxable income, be prepared to claim less if you refinance and your mortgage payment is significantly lower.

If you take the standard deduction, this factor doesn’t affect you since you can automatically take a $15,000 deduction for single filers or $30,000 for married couples filing jointly in 2025 (up from $14,600 or $29,200 for 2024).

Loan Consolidation as an Alternative

If your mortgage is just one type of debt you have and you’re trying to get a handle on your personal finances, consider another option: loan consolidation. Instead of refinancing your home, which uses your home as collateral, you might focus on consolidating your other debts into a single loan so they’re more manageable.

For instance, you can combine your student loans, credit card debt, medical debt, and personal loans, so you’re paying only one bill. However, be aware that debt consolidation loans usually have higher interest rates.

Warning

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the United States Department of Housing and Urban Development (HUD).

Why Refinance Your Mortgage?

People refinance their mortgages for a variety of reasons, including to get a lower interest rate and monthly payments, to shorten the term of the mortgage, to convert from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage (or fixe-rate to ARM), or to access home equity.

What Is a Cash-Out Refinance?

A cash-out refinance is a mortgage refinancing option that lets the borrower convert home equity into cash. In this scenario, a borrower takes out a new mortgage for more than the previous mortgage balance, and the difference between the two is paid out in cash.

Should You Refinance Your Mortgage When Interest Rates Decline?

In some cases, lower interest rates may result in mortgage rates that are lower than what you are paying currently, making refinancing a viable option. However, lower interest rates could still leave mortgage rates at a higher level than the mortgage rate you already have. If you can negotiate a lower interest rate and intend to stay in your home long enough to cover the refinance closing costs, then refinancing could be the smart choice.

The Bottom Line

When interest rates drop, it might seem like everyone rushes to refinance. However, it’s crucial to do your own research to determine if refinancing makes the most sense for you. For instance, once you compare all the costs to how much you actually stand to save, you’ll have a better idea. If you’re still unsure whether refinancing is the right move for you, consult with a financial advisor.