Will savings on refinancing outweigh closing costs? First do the math

Would a mortgage refinance make sense for you? You’ve probably had the conversation at some point in time. Perhaps a family member or neighbor has told you about the great deal they got by refinancing their mortgage. Now you’re left to wonder: Are you losing out if you don’t follow suit?

There are times when droves of homeowners rush to refinance (usually because of a drop in interest rates). However, rates aren’t the only reason to replace your current loan, nor is it the case that an ideal time to refinance for one borrower is necessarily a good opportunity for someone else.

Before jumping into a decision, it’s important to understand why you’d want to take out a new home loan in the first place—and then to figure out whether it makes sense in your particular circumstances.

Key Takeaways

  • Reasons to refinance a mortgage include lowering your interest rate, switching to a fixed rate from an adjustable-rate mortgage (ARM), or taking cash out of your home.
  • When shopping around for a new mortgage, remember to look not just at interest rates but also at closing costs, good faith estimates, and the breakeven point.
  • Consider using the services of a mortgage broker but do your own legwork to make sure you get the best deal.
  • Decide whether you want to use points to lower the interest rate and remember to lock in the rate once you have a good offer.
  • Get your credit reports to see what your credit score is and check for errors, because great credit can help secure a better refinance package.

What Are the Reasons to Refinance?

There are obvious and less obvious reasons for refinancing.

1. Falling interest rates

This is the most obvious reason to refinance. When interest rates fall, a new loan means lower financing costs. Perhaps you took out a 30-year fixed mortgage when rates were at 6%, and now they’re down to 4.5%. On a $300,000 loan, that rate drop alone would lead to a $279 reduction in your monthly payment.

In a case like that, doing a refi might sound like a no-brainer, but you should keep in mind that taking out a new loan means paying new closing costs, and those may or may not be worth the savings from a lower rate, depending on how long you expect to live in your home. As a general rule, the longer you plan to stay in place, the more it makes sense to refinance and eat those one-time fees. Nevertheless, you’ll have to work the numbers to know for sure.

2. Replacing an adjustable-rate mortgage (ARM)

One good reason to refinance is if you have an adjustable-rate mortgage (ARM) that you’d like to convert into a fixed-rate loan. An ARM is a loan that offers a low introductory interest rate that “resets” after a predetermined period of time (whether it’s one year from your closing date, five years, or more). If interest rates have gone up when the loan resets, borrowers can be in for a shock when they see their new monthly payment.

That’s why borrowers will often try to refinance into a fixed-rate loan before the reset date, especially when rates are relatively low by historical standards. The fact is that no one knows what will happen to interest rates down the road. Therefore, opting for a safer bet is usually a good idea, especially if you plan to be in your home for a while.

Costly ARM resets were one of the factors that led to the subprime mortgage crisis that occurred between 2007 and 2010. Home loans with an adjustable rate are not nearly as common as they were back then—although they’ve been making a comeback in the past few years. If you have one, staying a step ahead of potential trouble can be a wise idea.

3. Your credit score has improved

Perhaps you took out a home loan when your credit score was a lot lower than it is now, leading to a higher-than-average interest rate. Since then you’ve reduced your debt balances, perhaps even regularly sending in your payment before the due date. Your ability to pay back the loan on time is one of the biggest factors in determining your mortgage interest rate.

Lenders make an educated guess by gathering your credit score, which reflects your borrowing and repayment history. If your credit score has improved enough, you may be eligible for a substantially better rate.

4. Lengthening the loan term

Even when their rates are the same, some homeowners are able to lower their monthly payment by refinancing. They simply take out a new loan with a longer term.

Say, for instance, that you took out a 30-year mortgage for $250,000. Ten years later that loan balance is down to $200,000. By taking out a new 30-year loan for the remaining balance, you’re lowering your monthly payment, but you’re also tacking 10 additional years onto your loan.

Extending your loan term might make sense if you’re having trouble keeping up with your payments. Still, make no mistake—by stretching out your mortgage, you’ll be paying more interest in the long run.

5. Taking cash out of your home

Among the perks of owning real estate is the opportunity to build equity over time. When times suddenly get rough, as they have with the COVID-19 pandemic, a home can be a source of needed low-cost cash. Mortgage relief may help for a time, but it may not be enough for your needs.

One way to get money out of your home is to refinance with a bigger loan, leaving you with extra cash that you can use for a variety of needs. This is known as a “cash-out refinance,” and to do it you’ll need to stay within the loan-to-value (LTV) ratio threshold for your loan program. The LTV ratio is the amount of the mortgage divided by the appraised value of the property.

Let’s say you own a home worth $200,000 and still owe $120,000 on your mortgage. If your lender has an 80% LTV, you could refinance into a $160,000 loan and take out the $40,000 difference in cash. Remember, however, that you’ll be paying closing costs to get that new loan—and you’ll have less equity coming your way when you eventually sell the property. 

If you refinance to pay off high-interest debt, don’t fall into the trap of running up that debt again once you have access to more credit.

It very well might be worth doing if you’re putting the money to good use, such as paying down a high-interest-rate credit card, doing a renovation that will increase the value of your home, or meeting a need for money to stay afloat during a difficult period. Refinancing to have money to buy a boat, go on an exotic vacation, or pay for a wedding, however, makes less sense.

Bear in mind that there are other ways to tap the money in your home, such as a home equity loan or home equity line of credit (HELOC), from which you can draw on an as-needed basis. Comparing the pros and cons of each will help ensure you make the best choice.

How to Get the Best Deal on Refinancing

If only shopping for a mortgage were like buying a TV—simply a matter of checking stores and online to see exactly how much you’d have to pay. Unfortunately, searching for home loans is a little more complicated. Different lenders will offer different rates—not to mention different fees—depending on such factors as your credit score, employment status, and the LTV ratio. The only real way to make sure you’re getting the best deal is to shop around with a handful of providers. You might want to include a mix of bigger banks, as well as local banks and credit unions, to see who can offer you the most attractive terms.

It can be tempting to visit an online marketplace that promises instant quotes from a variety of mortgage companies. Keep in mind, however, that the numbers they provide are often estimates, not actual offers. Furthermore, you don’t always have control over how widely the personal information you provide will be shared with other parties. That's why contacting reputable lenders one at a time, even if it’s more time-consuming, is usually a good idea.

When shopping around, don’t just look at the interest rate. Even before you formally apply for a refinance, you can ask the lender if it will provide a “good faith estimate” that details how much you’ll also have to pay in closing costs. In some cases paying a slightly higher rate if it comes with lower upfront fees may actually work out to your advantage.

In order to determine rates, each lender will have to pull your credit report, which can temporarily lower your credit score. You can minimize, or even eliminate, the impact on your score by doing your research over a short period of time. The company that develops FICO scores, for example, doesn’t ding you (or not much) for mortgage inquiries made within 30 to 45 days of scoring, depending on which version of the FICO formula the lender uses.

Can You Get a Better Refinance With a Mortgage Broker?

Approaching multiple mortgage providers might seem like a lot of work, especially if you have a limited amount of spare time. That’s one of the benefits of working with a mortgage broker, who compiles your information and contacts multiple lenders on your behalf. It’s like a one-stop shop for your mortgage needs.

Because brokers are paid by the banks and mortgage companies with which they work, you don’t need to pay them directly for their services. Plus, lenders sometimes reward them for bringing in customers by providing them with special rates.

Still, there are drawbacks to outsourcing your search. Brokers may get compensated for putting you into a bigger loan, for example, even if it’s not in your best interest. And certain lenders don’t work with brokers, so it can sometimes limit your options.

There’s no problem in using both methods, though. You can use a broker to do the heavy lifting but look for one or two quotes on your own to see how they compare and find the best lender for you.

Locking in Your Rate: Know the Strategy

Predicting where interest rates will move weeks ahead of time is a fool’s errand—not even the banks know where they’re headed. Once you’ve found a good offer, it’s always a good idea to lock in your rate, so you know it’ll be the same by your closing date.

Suppose, for example, that the bank estimates you can close on the loan within 30 days. You might want to ask to lock in your interest rate for 45 days to make sure it doesn’t inch upward by the time you finalize the note.

Getting a mortgage rate lock that’s longer than needed doesn’t always work in your favor, however. Whenever banks freeze their rate, they’re assuming the risk should interest rates edge upward, so they’ll often compensate for a longer lock period with a higher rate or additional fees.

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 you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

Points or No Points?

Another way to get a lower interest rate on your loan is to pay “points,” which are prepaid interest on your note. Each point is the equivalent of one percent of your loan value, so paying two points on a $200,000 mortgage means you’re forking over $4,000.

In exchange, the lender offers a lower rate, which may benefit you if you stay in your home long enough. And as with interest that you pay over the course of the loan, the amount you pay in points is generally tax deductible. (This assumes that it still makes financial sense for you to itemize your deductions rather than take the new higher standard deduction introduced in the Tax Cuts and Jobs Act of 2017.)

Of course, you’ll need to have a little extra cash at closing time to take advantage of using points. If, on the other hand, you’re looking for the lowest possible upfront cost on your refi, you’re better off avoiding prepaid interest and living with a slightly higher interest rate.

What Will Refinancing Cost?

The prospect of a significantly lower interest rate on your loan can be tempting for any homeowner, but before proceeding with a refi, you really need to know what it’ll cost. Often what seems like a great deal loses its luster when you see the fees.

This is why it’s important to compare the good faith estimates from various lenders. These documents include the interest rate as well as a breakout of the projected expenses to close the loan.

One of the biggest outlays is the lender’s “origination fee.” You’ll also face a range of other charges, such as costs for an updated appraisal, title search fees, and the premium for title insurance. All those costs can total up to as much as 5% of the loan’s value.

Determine the Breakeven Point

Unless you intend to stay in your home for a long time, those upfront costs might make a refi prohibitive. To figure that out, divide the closing costs by the amount you save each month from your new interest rate. The result is the number of months it’ll take before you break even on your new loan.

If you itemize your tax deductions, just make sure to adjust the amount you save on interest by your marginal tax rate, since the government is essentially giving you a discount on your financing costs.

You’ve probably heard of lenders offering loans with no closing costs, which might seem like the perfect way to save some cash. Unfortunately, there’s a catch: The lender has to charge you a higher interest rate in order to account for those expenses. If you remain in your home long enough, you could be better off forking over the fees now in exchange for a lower monthly payment.

The Importance of Credit Scores

Economic trends have a big impact on the interest rate you’ll receive. Fixed-rate mortgages, for example, tend to move in lockstep with the yield on a 10-year Treasury bond.

Individual factors also have a lot to do with your rate. Your income and job history play a significant part, as does your credit score, which is based on information in your credit report. The higher your score, the lower the rate you’ll have to pay on your new loan.

According to the website myFICO, in 2021 a borrower who has a score of 760 or higher will typically pay $190 less per month on a 30-year, fixed-rate mortgage worth $216,000 than someone with a score of 620, which amounts to $2,280 less per year. The rate difference in this example is 2.6% vs. 4.19%.

Improving Your Score

It pays, then, to get your credit score as high as possible before starting the refi process. Many credit card providers offer them for free, although some use scoring systems other than FICO, the most widely used model. You can also buy your score from myFICO.com.

You will also want to look at your actual credit report from all three reporting agencies: Experian, Equifax, and TransUnion. Fortunately, you can get a free copy of each once a year at annualcreditreport.com. Make sure the information on your existing credit accounts is accurate. If you spot an error on your report, you’ll want to contact the appropriate credit bureau so it can investigate.

Due to the hardship caused by the COVID-19 pandemic, the three credit reporting bureaus are offering free weekly credit reports via AnnualCreditReport.com through April 20, 2022.

Barring any major errors on your report, it can take time to boost your numbers. The biggest factors affecting your score are your amounts owed and payment history, which together make up a whopping 65% of your FICO number. So the best thing you can do to lower your mortgage rate is to reduce your other loan balances and always make your payments on time.

The Bottom Line

There’s no one-size-fits-all answer to whether refinancing your mortgage makes sense. In most cases it comes down to math. If the amount you save on a monthly basis will eventually eclipse the closing costs, taking out a new loan can be a wise move. 

If you do pursue a refi, comparing offers from multiple lenders is the surest way to get the best deal. Once you’ve found it, you’ll want to lock in the rate to ensure you’re not stuck with higher interest fees once the closing date rolls around.

Article Sources
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