- Refinancing your mortgage can help cut your monthly bills or it could shorten the loan term. In some cases, you may be able to do both.
- If you're thinking of refinancing your mortgage, consider the cost, your goals, and the number of years left on your current loan, among other things.
- Check your credit report before applying for a new loan and consider applying with several lenders to be sure you're getting the best rate at the lowest cost possible.
For many people, housing is the biggest monthly expense. For homeowners, refinancing a mortgage when mortgage may be an easy way to lower housing costs or shorten the loan term.
Refinancing your mortgage can make sense when mortgage rates are low—or if your home has appreciated in value and refinancing could remove a requirement to pay private mortgage insurance (PMI). Before you start looking for loans, it's important to understand the costs as well as your long-term goals.
What drives mortgage rates
While the fed funds rate is a key benchmark for many consumer loans like credit cards and car loans, it does not directly affect most conventional mortgages. Instead mortgage rates are generally tied to the 10-year Treasury yield.
When Treasury yields go down, mortgage rates typically follow. Because the price of bond moves in the opposite direction to yield, treasury yields fall when the demand for Treasury securities goes up. The question for homeowners may be, does it make sense to evaluate a mortgage refinance? If you’re asking that question, here are some steps to take.
Do your homework
Consider your goal first. Are you trying to lower your monthly payment or lower the total amount of interest you'll pay over the life of the loan? And it's important to consider how many years are left on your current loan.
If you're 10 years into a 30-year loan, refinancing to another 30-year loan with a lower interest rate means you're back to square one, with 30 years of monthly payments ahead of you. Your monthly payment may be lower due to the lower interest rate and longer loan term but your overall interest costs will likely go up as the net effect would be adding 10 years to your loan—it depends how big the difference is in interest rates.
In order to save money over the lifetime of the loan, you could consider refinancing into a 20-, 15-, or 10-year mortgage. Depending on the interest rate difference between your existing mortgage and currently available options, that may raise your monthly payment, but it could dramatically reduce the amount of interest you pay over the lifetime of the loan.
Check your credit score
No matter how low interest rates go, your credit score has a big impact on the interest rates a lender will offer on a loan. Be sure to check your credit report for errors and ensure that your debt -to-income ratio is in a range that makes lenders comfortable.
These are some general guidelines that lenders use to evaluate your debt relative to income. First, they may consider how much of a bite housing payments take out of your total income—ideally 28% or less of gross income would go to housing. They also look at your total debt payments relative to income. In general, lenders prefer that total debt payments, including car or student loans, credit cards, and your house payment, not exceed 36% of your total income as a general rule.1 Individual lenders may have stricter or more lenient guidelines.
Consider refi costs
The cost of a refinance can be significant—3%–6% of your outstanding principal, according to the Federal Reserve Board. It may take some calculations to see if a refinance would help you save money after the upfront cost. There are many online calculators that can help here.
Just like taking out an initial mortgage on a property, refinancing involves closing costs. They can include the cost of an appraisal, application fees, and even attorney fees. You may have options for paying some of these fees and expenses. Paying them up front can often be the least expensive option. If you can't afford to pay the closing costs up front, your lender may allow you to roll them into the loan. Though you won't pay money today, you'll end up paying interest on those fees and expenses over the life of the loan. Alternatively, your lender may also offer the option of a higher rate loan in exchange for no closing costs.
If you need private mortgage insurance, which is usually required if your equity is less than 20% of the value of your home, that can be another cost to consider.
Read Viewpoints on Fidelity.com: How to pick a mortgage: 5 considerations
Your taxes may be affected by refinancing as well. If you itemize, you may be accustomed to getting a deduction for the interest paid on your home loan. A change in the interest rate could change the amount of your deduction, which may be a consideration for tax planning. The degree to which your taxes could be affected depends on the number of years paid on the original loan, the new loan term, and as discussed below, on the size of the loan balance.
If you have a loan for more than $750,000, up to $1 million, that was taken out before December 15, 2017, another consideration may be the limits established by the Tax Cuts and Jobs Act (TCJA). The TCJA limited the home mortgage interest deduction to interest paid on the first $750,000 of a mortgage. Refinancing more than that amount could lead to a smaller deduction if the original loan predates the new law.
When you refinance, interest initially becomes a larger portion of the payment relative to principal. That may end up increasing the amount of mortgage interest you're able to deduct—at least on the first $750,000 of your loan.
With an adjustable-rate mortgage (ARM), the interest rate is fixed for a predetermined number of years, and then it fluctuates, within limits, for the remaining term of the loan. An example is a 7/1 ARM. The 7 refers to the number of years before an adjustment can be made. After the seventh year, the loan may adjust every year. Rate changes are determined by a benchmark index plus a margin percentage set by the lender.
If you currently have an ARM and are concerned about rate resets in the future, it can make sense to refinance into a fixed-rate loan to take advantage of lower rates. Some of the considerations include when your current loan resets and how long you plan to live in the home. There may be caps on how much your rate could adjust each year and over the lifetime of the loan.
What else should you know?
- If you're planning to move in the next couple of years, refinancing doesn't make sense. To know when it does make sense, calculate your breakeven point. Start with the cost of refinancing and then divide it by the amount of money you'll be able to save each month by refinancing. That will give you a rough idea of how many months it will take for your refinance to pay off.
- Be sure to check rates across a range of lenders. To get started, check rate aggregator sites that show sample interest rates (like Bankrate.com and NerdWallet.com) to understand the rates you may find. There are also websites that can give you a more personalized rate from multiple lenders (like Credible and Lending Tree). Sometimes the best deal isn't available through a bank—credit unions or dedicated mortgage lending companies may offer competitive rates.
- You can apply for a mortgage refinance with multiple providers as you shop around. Each lender is required to provide a loan estimate within 3 days of your application. The full approval process will require a more in-depth review of your finances. Some of the documents that may be required include proof of income like recent paystubs and W-2s and proof of homeowners and title insurance. You may also be asked for bank statements.
- The good news is that credit scoring models generally allow 2 weeks to 45 days for multiple credit inquiries as you look for the best deal.2 It could be a good idea to do your shopping in the 2 week window just to be safe. Each time you apply for new credit, it shows up as a hard inquiry on your credit report, which could ding your score. Bundling all inquiries of the same type, like home or car loans, made in a specific time period into 1 inquiry, lessens the impact on your score.
Understand how your financial plan may be affected
Housing is typically the biggest item in a family's budget. If you are able to lower your monthly mortgage payment with a refinance, consider how you may be able to put those savings to work based on your goals and priorities.
Pay down your mortgage faster. If your monthly payment fell after refinancing, you could consider paying the loan off faster by continuing to pay your original payment rather than the new, lower one. That could help pay down the loan more quickly and save money on interest.
Save more for retirement or other goals. You may be able to speed up your retirement timeline by funneling the money saved on your mortgage into retirement savings. It could also provide an opportunity to build up your emergency fund or save for something else.
Pay down other debts. Consider putting the extra cash in your budget into debt payments if you have any lingering balances—particularly those with high interest rates.
Increase your living expenses. If your retirement savings are on target, your emergency fund could cover at least 3 to 6 months' worth of essential expenses, and there's no debt to pay down, you may be able to increase your discretionary spending.
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