What to consider before refinancing your mortgage

Congrats! You own a home. As we know, that’s the single best way to build generational wealth (and also, you know, have a roof over your head). Here’s what’s not so good: Chances are, you’re paying a higher interest rate than you would be if you bought that very same house today.

Here’s why: The average interest rate on a 30-year fixed-rate mortgage dipped to a record-breaking 2.88% in early August — the lowest rate reported in almost 50 years. So if you bought a house in the last five years, it’s a little like the feeling of buying, say, a sweater, and seeing it on sale just a few days later.

The good news is you can almost certainly refinance your home, and get a mortgage at this newer, lower rate. In fact, because rates are so low, it might sound like a no-brainer to refinance your mortgage. After all, why wouldn’t you want to trade in a higher interest rate for a lower one? But the reality is, interest rates are only one factor, albeit an important one, when it comes to things you should think about before refinancing. This

When you factor in fees and your future plans into the equation, refinancing may not always put you on top financially. We spoke with two mortgage experts who broke down these five factors to consider when you’re deciding to refinance your mortgage.

Factor #1: What’s happening in the mortgage rate market

Let’s start with those aforementioned interest rates.

Whether you want to lower your payment or change from an adjustable-rate mortgage to a fixed-rate mortgage, start watching how interest rates are moving so you can lock in the best possible rate. “Right now, the time is perfect with interest rates being at a historical low,” says Benjamin Schandelson, a loan officer at MJS Financial LLC in Florida.

Although mortgage rates have been around 3% for two months, the rate you actually qualify for may vary. “[Lenders] adjust your rate based on risk factors,” says Ralph DiBugnara, a New York City based mortgage banker and president of Home Qualified, a digital resource for homebuyers.

The three major risk factors are the type of property you own, the equity you have in the home, and your credit score, according to DiBugnara. To secure the best possible rate, you may want to consider taking steps to raise your credit score before refinancing. These steps include correcting any errors in your credit record, and making sure you pay all your bills on time (if not early). Also, shop around with multiple lenders to compare offers — in this day and age, there is no shortage of mortgage lenders you can consider.

Factor #2: The cost of refinancing versus the potential savings

You know that old saying that you have to spend money to make money? Whoever said that must have refinanced their mortgage, because it absolutely applies to the process. What

Here’s what we mean: Remember those fees you paid when you bought your home? The ones with strange, vague names like origination fees and appraisal fees, not to mention credit report fees and more? We hate to break it to you, but those will all pop up again when you refinance.

In fact, closing costs for a mortgage refinance may come up to 3% to 6% of the loan amount, says Schlandelson. Plus, your lender may charge you what’s called a prepayment penalty fee for paying off your current mortgage early with a refinance.

Add it all up, and you’ll be paying a decent chunk of change to get that lower interest rate. So the question becomes: When does refinancing make financial sense? “You want to be able to recoup the closing cost in less than two years worth of savings,” says Schandelson. “This is a good rule of thumb to know if the refinance is worth it.”

Why two years? If it takes longer than two years to break even, the refinance may not be worth the hassle, especially if there’s a chance you could move. (And a lot can change in two years, from having children that require more space, or changing jobs.)

The amount of time it takes you to recoup the cost is called the break-even point, and calculating that break-even point is simple. Here are the three key steps:

1. Add up the refinancing costs

Look at the loan estimate you get from the lender to see what the closing costs would be; add the prepayment penalty fee if there is one.

2. Calculate the monthly savings

Subtract the new monthly payment from your current monthly payment. The difference is how much you’ll save each month.

3. Find the break-even point

Divide the refinancing costs by the monthly savings to see how long it will take for the savings to cover the refinance.

For example, if your current mortgage payment is $1,725 and your new payment would be $1,475 — that’s a savings of $250 per month. If your estimated refinancing costs are $5,000, it would take less than two years to break even ($5,000 divided by $250 equals 20 months). The monthly savings past 20 months will be money in your pocket.

Factor #3: What you have available to pay out-of-pocket

Say your closing costs add up to $5,000 — that’s no small sum of money, and you’ll need to pay it up front. And because interest rates are at a record low, you could feel pressure to strike while the iron’s hot, even if you don’t have that much cash. In this case, options like no-cost refinancing might look enticing.

A “no-cost” refinance is not a free refinance; instead, the lender will pay the closing costs for you and charge you a higher interest rate to cover the cost. Even if you take a higher interest rate, streamlining an FHA loan with a no-cost refinance could still lower your payments since rates are so low, says DiBugnara. It’s a lot of math, to be sure, but running those numbers might save you money in the long run.

Another way to pay less upfront is to roll your closing costs into the loan balance. This might increase your monthly payment, which means it could take you longer to break even. Ask the lender to calculate each scenario — paying costs upfront or paying them throughout the loan term — so you can compare the monthly payment and savings before making a decision.

Factor #4: How long you plan to stay in the home

The usual piece of advice is not to refinance if you plan on moving soon. Again, that’s just math. Let’s use the above example. If it costs you $5,000 in fees to refinance, and you move after six months, you’ll have spent 5K to have saved $1,500. That’s… not ideal.

That said, we’re in an unusual time: Schandelson notes that rates are low enough that your savings over even just two years could still add up.

If you’re in your “forever” home, you need to pay close attention to the long-term cost of refinancing and not just monthly savings. Refinancing five or six years into a home loan with another 30-year mortgage can extend your repayment term, which can cause you to pay more overall.

However, in some cases, an increase to overall costs may not be a dealbreaker. If you’re in a starter home or you plan to move across the country within the next five years, for example, your monthly payment savings likely matters more than long-term savings since you plan to sell anyway.

Factor #5: Your income and odds of approval

Besides the external factors to consider, such as interest rates and fees, there are internal factors to think about as well. The economic downturn caused by the pandemic has made money cheap to borrow at a time where millions of people are facing a loss of income. If you experienced a job loss or a furlough in the last few months, you could have trouble qualifying for a refinance.

“Since COVID, lenders are getting serious about the paperwork. They want to see you are still working and signs of continuous work,” says Schandelson. Having W2s, pay stubs, or bank statements that show you’re back to work and making consistent income can help you get through the refinance process faster.

For self-employed workers, it may have been challenging to get a loan before COVID-19. Now, DiBugnara says, lenders have gotten more stringent. Lenders typically look at your income over the past several years to calculate an average for your application since self-employed workers don’t have the same tax documents as employees.

Now, past income isn’t always a good indicator of current earnings since many businesses have taken a COVID-19-related financial hit. Because of this, lenders may request additional paperwork such as bank statements or a letter from your accountant to confirm you earn enough to repay the loan before offering you a refinance.

To refinance, or not to refinance: that is the question.

Ultimately, whether or not refinancing is the right move for you depends on a range of factors that only you can know. Again, these include both the terms of your current mortgage and the terms you can get for a refinanced mortgage; the amount of cash you have on hand; how much you’ll save in the short- and long-term; and how long you plan to stay in your house. 

If the amount you’ll save is minimal given the cost, refinancing may not be worthwhile. However, if the refinance can knock your payments down by several hundred dollars per month and you can break even relatively quickly, it could have a positive impact on several areas of your finances. The monthly savings could go into other financial goals like saving for retirement, building up your emergency fund, or repaying student loan debt — the options are endless. If it all works out, congratulations: There’s nothing quite like the satisfaction of saving a little — or a lot — on a payment you’re literally making every month for decades to come. Enjoy.

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