Refinancing Explained: What Is It, and When Should You Do It?

Shefali Lohia
September 30th, 2021 | 12 mins

The world of home buying and home owning can be an absolute doozy. There are a lot of complicated terms and processes you need to be aware of in order to make the smartest decisions for your particular financial situation and goals. In this article, we walk through the typical reasons for refinancing your home—a process lots of homeowners undertake depending on their financial needs and external factors, like going interest rates.

What is refinancing?

On the most basic level, refinancing means replacing an existing loan with a new loan that pays off the debt of the first one. Ideally, the new loan should benefit you with better terms or features that improve your overall financial situation.

When you refinance the mortgage on your house, you swap out your current mortgage for a new one, often with a new principal and a different interest rate. Your lender then uses the newer mortgage to pay off the old one, so you’re left with one loan and one monthly payment.

Other types of loans that people typically refinance are student loans, auto loans, personal loans, and small business loans.

When should you consider refinancing your mortgage?

While there are typically a few different reasons for which people consider refinancing the mortgage on their house, the bottom line is that refinancing should clearly benefit your financial situation and needs—ideally in both the short and long term.

Here are some of the common reasons for refinancing a mortgage:

1. To change the loan term

A typical reason people consider refinancing is to change the term of their loan, from a 30-year term to a 15-year term, or vice versa.

If you can afford a higher mortgage payment, it might make sense to switch from a 30-year term to a 15-year term, pay off your mortgage sooner, and save on interest in the long run.

You might also consider switching from a 15-year term to a 30-year term to lower your monthly payment. This can be an extremely helpful choice if you find yourself with less wiggle room in your budget. That said, while lowering your monthly payments by lengthening your loan term can make sense in the short term, it might cost you more—a lot more—in total in the long term when you account for interest. Make sure you take a look at the big picture before you take this step.

2. To lower your interest rate

Another typical reason people consider refinancing their mortgage is to lower their interest rates.

Interest rates are always changing, and chances are, sooner or later, your rates may be lower than when you first got your loan, at which point, refinancing may be a fantastic option.

You can also qualify for a lower interest rate if your credit score is higher than it was when you first applied for the loan. This is because lenders take your credit score into account—as a general indicator of how good you are at managing your debt—when they decide on your interest rate. The better your score, the better your rate.

In either situation, there are clear benefits:

  • Lower interest rates would lead to lower monthly payments and mean that you pay less interest over the life of your loan.
  • Homeowners might also have the chance to refinance and decrease their loan term, with little change in their monthly payment. For example, depending on the interest rates, you could go from paying $800/month on a 30-year term, to paying $850/month on a 15-year term!

Both paths lead to less money spent in the long run. Historically, experts have said you should consider refinancing if you can reduce your current interest rate by 1% or more.

3. To change the loan type

There are two types of mortgages:

  • Adjustable-rate mortgages (ARMs) have interest rates that vary depending on how long the loan has been held. The initial interest rate on an ARM is typically lower than market rate (and is constant for a specified period of time, usually 5, 7, or 10 years), and then rises as time goes on (again, according to a specified schedule). If an adjustable-rate mortgage is held for a long-enough period, the interest rate can surpass the going interest rate for fixed-rate loans, sometimes by a lot.
  • A fixed-rate mortgage is just that—a loan where the interest rate is fixed for the term of the loan.

Typically, people consider switching from an ARM to a fixed-rate mortgage if they’ve held the ARM long enough that their interest rate is extremely high (and will only continue to get higher until the loan is paid off) compared to the going interest rate for fixed-term mortgages at that time.

You might also consider refinancing from a fixed-rate mortgage to an ARM, though this move usually involves risk, and is likely only beneficial for a small percentage of people. It could be a smart move if interest rates are falling extremely low (and therefore refinancing to an ARM would get you an even lower interest rate), or if you’re planning to sell your house during the initial period of your ARM (during which interest is typically lower).

4. To cash out

One subset of refinancing options is a cash-out refinance. In this situation, you borrow more than you owe on your house and pocket the difference as cash, which you can use towards other purposes. Common reasons people consider cashing out is:

  • To pay off other debts and/or consolidate debt
  • To finance home improvements or renovations
  • To allocate money towards retirement or other investments

We know, this sounds crazy at first blush, but there is logic! When you refinance in this way, you are essentially taking out a portion of your home’s equity or value, in cash.

Equity refers to the amount of a house’s value that you’ve actually paid off. Two things contribute to your equity:

  • When you pay down your mortgage principal through monthly payments, you gain a bit more equity in your house with each payment
  • When your house increases in value

Here’s an example of how a cash-out refinance would work: Let’s say you bought a house for $300,000, and you’ve paid off $90,000 (your equity). This means you still owe $210,000. Let’s say you want $30,000 cash for other purposes. With a cash-out refinance, you could take a portion of your equity (in this case, $30,000’s worth) and add it to the amount owed, giving you a new mortgage that would be worth $240,000. You would then receive the $30,000 in cash.

The key benefit to note here is that using cash from your home in this way usually allows you to borrow money at a much lower interest rate than other loan types, for example, on a credit card.

It’s also important to note that lenders typically won’t let you draw more than 80% of your home's value. (In the above example, the equity was $30,000 divided by $300,000, meaning 10%.) A major exception to this rule is VA loans, which let you take out up to the full amount of your existing equity.

Other considerations of refinancing

Before we let you go, we need to note a couple of other important considerations that are vital to take into account when you’re consider refinancing:

Associated fees and costs

Refinancing is expensive! Costs vary lender-to-lender and state-to-state, but you can count on paying a large percentage (typically 2% to 6%) of the outstanding principle in fees and costs, which include title insurance, attorney’s fees, an appraisal, taxes, transfer fees, and more.

You need to account for these costs when considering refinancing to get a sense of whether it’s worth it. Remember, you’ve paid these closing costs at least once before—when you took out the original loan.

Do your homework

We cannot stress this enough. Refinancing is complicated. Make sure you do your homework before you make any moves.

  • This article is just an overview! If you’re consider refinancing, make sure to dig deeper and understand the ins and outs of the process
  • Check your math! Find a handy dandy mortgage calculator online to help you understand what the numbers could look like for you
  • Consider working with a professional who can help you assess all options and long-term ramifications before making any moves

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