Use this guide to understand when and how to refinance your home. Content includes loan options, general requirements, and finding your 'break-even point.'
Phone calls, emails, postcards — even your neighbor. One way or another, you’ve probably heard that it's a great time to refinance your home when mortgage rates are low.
That's largely true, but there’s more to this question than meets the eye. Mortgage rates are trending upward from historic lows in 2022, which has slowed demand for refinances. But it’s not the only factor to consider.
In this guide, we’ll explain how to decide whether and how to refinance your home.
Deciding whether to refinance your home should “depend on your goals and purpose of the refinance,” says Garett Seney, a mortgage adviser with Fairway in South Boston, Massachusetts.
Most people refinance for one or more of the following reasons:
It’s possible for a refinance to accomplish all of these goals at once: A new loan could lock in a lower, fixed rate, change your loan term, unlock cash back from equity, and eliminate mortgage insurance.
“The most common reason to refinance is to lower your rate and payment.”
Craig Tashjian, senior mortgage consultant
But achieving only one of these goals is reason enough to refinance.
Still not sure whether refinancing is the right move?
“Sit down with your trusted mortgage advisor and they can break down each scenario for you on why it does or does not make sense to refinance,” Seney suggests.
All refinance loans have one thing in common: They replace your existing mortgage with a new one. When you close on the new loan, your current mortgage gets paid off, and you start making payments on the new loan.
You may receive mailers that claim you can “reduce your rate instantly” or even “reduce the rate on your existing loan.” Typically, these are just offers to replace your existing loan with another one.
Whatever the offer, the new mortgage should improve your situation. What can a new mortgage offer than your current one can’t? That depends on the type of refinance you’re getting.
This refers to a refinance where you will change your rate, term (loan length), or both. For instance, if you have a 30-year mortgage, you could refinance to a 15-year to save on interest long-term. Or, you can refinance to another 30-year mortgage at a lower rate. By extending the repayment period, you may be able to reduce your monthly payments, making them more manageable.
However, you’ll want to make sure you’re actually saving money with the refinance. A refinance is generally worth it when you can recoup your closing costs with interest savings in about 2 years. More on this below
With a cash-out refinance, you borrow against the equity you’ve built up in the home – you’re taking “cash out” of the house. You can use these funds however you choose. The drawback is that the new mortgage loan will be larger than your current one, and it will take longer to pay off
This special type of refinance works only if you have a government-insured loan such as an FHA, VA, or USDA loan. Streamline refinances are similar to standard rate-and-term refinances except with less red tape. In many cases, you can refinance for a lower rate or longer term without a credit check or home appraisal with a streamline refinance (assuming you are refinancing to the same type of loan)
“The most common reason to refinance is to lower your rate and payment,” says Craig Tashjian, senior mortgage consultant with Fairway in Newton, Mass.
But changing your loan’s term is a big deal, too.
“If you took out a 30-year term the first time, you don’t necessarily take out a new 30-year loan,” Tashjian says. “If you’ve had your mortgage for several years, you may consider reducing your term to a 15- or 20-year mortgage to pay it off quickly.”
A shorter loan term can save you a lot of money in the long run, but it will usually come with higher monthly payments.
Some loan types require waiting periods before a refinance. To replace a VA loan with another VA loan, for example, you’d need to wait at least six full monthly payments have been made. The FHA has a similar rule.
Even if your loan and lender don’t require a wait, you may be short on another requirement: equity. Most refinance lenders want to see at least 20% equity built up in your home before you refinance.
For example, if your home is worth $300,000 but you owe $270,000, you’d have $30,000 in equity, which is only 10%. That’s not enough for most refinance loans. If you can refinance, it will come with new mortgage insurance, potentially negating any savings. Some lenders will make exceptions to this 20% rule for borrowers who have excellent credit.
But streamline refinances are different. With an FHA streamline or VA streamline refinance, you can refinance with little or no equity – or even be underwater – and still be approved (often with no appraisal, no income verification, and no bank statements, depending on the program).
Equity is a particular requirement for cash-out refinances, since you need a certain amount of equity to borrow against, and most loan programs will not allow you to borrow against the full value of your home. That means you need enough equity to borrow against, with a buffer amount left over.
The VA cash-out refinance is an exception to the rule. The VA lets qualifying veterans and active-duty servicemembers borrow up to 100% of their home’s value.
There’s no limit on how many times you can refinance. But it’s not something you’ll likely want to do often.
Why? For one thing, you’ll pay closing costs each time you refinance. These costs tend to range from 2% to 5% of your loan amount.
For a $200,000 refinance loan, closing costs would range from $4,000 to $10,000 — not a fee most homeowners want to pay over and over. Even a “no-cost refinance” isn’t really no cost, as these fees get translated into a higher mortgage rate. Which brings us to another risk when you refinance too many times: Paying too much interest.
Each refinance hits the reset button on your mortgage interest. Since 30-year, fixed-rate mortgages front-load the interest into the earliest years of the loan, refinancing too often means you’re constantly starting over instead of gaining traction to pay down your principal.
Plus, the savings from a refinance build gradually, month by month and year by year, as you make the new loan’s lower payments. Refinancing again pulls the plug on the savings you were set to accrue.
To know whether you should refinance, you’ll need to compare your new loan’s cost to its potential for savings.
For example, if you’d pay $6,000 in closing costs but save $30,000 in interest over the life of your new loan, refinancing is probably a good idea.
But, remember: That $30,000 in savings will happen gradually. In this scenario, on a 30-year loan, you’d be saving about $83 a month. At $83 a month, you’d need to make payments on the new loan for six years to recoup the $6,000 you spent on closing costs.
This time needed to recoup your closing costs is called your “break-even point.”
Refinancing into a shorter loan term is a great way to get to your break-even point a lot faster, though a shorter loan term will require a higher monthly payment.
Make sure you don’t plan to move or refinance again in the next couple of years. Set a goal to recoup your closing costs in about two to three years. Longer than that, and statistically most people will not have the mortgage long enough to enjoy real savings.
Qualifying for most refinance loans will resemble qualifying for your original mortgage. You’ll need to meet your loan’s:
As mentioned above, a streamline refinance such as the FHA Streamline, can help you bypass these requirements if you currently have the same type of loan.
There are a number of different refinance loans in the market. The right one will depend on your current loan, your goals for the refinance, your home’s value, and how much equity you have in the property.
How do I know if I should refinance my home? If the long-term savings outweigh the upfront costs, refinancing is probably a good idea for you, if you plan to keep the new loan long enough. If you plan to sell the home soon, the upfront closing costs and interests may outweigh any potential savings.
How long do you have to be in your home before you can refinance? Many loan types, such as VA and USDA loans, require a waiting period before you can refinance. Also known as a seasoning period, this waiting period can last from six months of fully payments to a year. You’ll also need to meet your lender’s other requirements, which include having sufficient home equity, before you can refinance.
Does refinancing hurt credit? Refinancing doesn’t necessarily hurt your credit, although your lender will pull your credit score. Any time a lender pulls your credit, a hard credit inquiry appears on your credit report and can temporarily lower your score. But if you can save significantly on interest through a refinance, or you can get a more affordable monthly payment, those benefits will eclipse any temporary effect the credit pull will have on your credit score. The best thing you can do for your credit is to pay your mortgage bill on time and in full each month.
How much equity should you have in your home before refinancing? Most lenders want to see at least 20% equity in your home before you refinance. For a cash-out refinance, you’ll need even more — enough to fund your cash out while leaving 20% equity in the home. You typically don’t need any equity to use an FHA or VA streamline refinance.
When interest rates drop, interest in refinancing spikes, says Jodalee Tevault, a senior mortgage consultant with Fairway in Chandler, Ariz.
But a refinance can accomplish more than locking in a lower rate.
In fact, even if you didn’t lower your rate, Tevault said a new loan “might make a world of difference to your overall quality of life.”
For example, you could use a cash-out refi to make home improvements or pay off high interest credit card debt, she said. A rate-and-term refinance that simply extends your repayment period and lowers your monthly payments can also make a world of difference if you find yourself strapped for cash.
But you don’t have to make the decision alone. Your lender can help you determine whether now is a good time for you to refinance, how much you can save, and which type of refinance loan is in your interest.
Fairway is not affiliated with any government agencies. These materials are not from VA, HUD or FHA, and were not approved by VA, HUD or FHA, or any other government agency.
*Debt-to-income (DTI) ratio is monthly debt/expenses divided by gross monthly income.
