4 steps to decide if you should refinance your mortgage

As mortgage rates plummeted to all-time lows this year, millions of homeowners flocked to the bank to refinance their home loans.

A refinance allows you to get a new mortgage (typically with better terms), pay off your current loan, and pay down the new loan over time. Mortgage experts typically recommend doing this if you can shave off 0.5% to 0.75% from your interest rate.

In August, mortgage data firm Black Knight estimated that 15.6 million U.S. homeowners who hadn’t refinanced yet could save $289 a month, on average, by swapping out their mortgage loans.

But refinancing isn’t the best move for everyone. If you’re thinking about shopping around, you’ve got to consider the costs involved and how long you plan to stay in the home. Here’s how to tell whether refinancing will actually save you money.

How much does it cost to refinance your mortgage?

The costs of the refinance—which may include closing costs, discount points, and a newly introduced adverse market fee—could eat into your savings. On a $200,000 refi loan, these could add up to $8,000.

Adverse market fee

As of Dec. 1, 2020, lenders have to pay an adverse market fee when selling certain loans to government agencies Fannie Mae and Freddie Mac. The fee, calculated as 0.5% of the loan amount, targets home loans that exceed $125,000. Lenders will likely pass on the cost to borrowers, says Dan Green, founder and CEO of Homebuyer.

“Borrowers can pay the adverse market fee as an out-of-pocket, line-item expense,” Green says. “Most will absorb it into their interest rate, though.”

If you have a choice between the two, it’s probably more cost-effective to pay the fee upfront instead of getting a higher interest rate, which will increase your costs over the life of the loan. A 0.5% fee on a $200,000 refi loan would cost $1,000.

Closing costs

You might remember closing costs from your last mortgage transaction—the fees you pay the lender to process the mortgage. According to Freddie Mac, refi closing costs typically reach $5,000. These vary, depending on the size of the loan and where you live, and may include:

• Recording fees
• Appraisal fees
• Credit report fees
• Lender origination fees
• Title services
• Tax service fees
• Survey fees
• Attorney fees
• Underwriting fees

Discount points

A discount point is an optional fee you can pay the lender upfront to reduce your interest rate. One point equals 1% of the loan balance. So on a $200,000 loan, for example, you can choose to buy 1 point for $2,000. While the amount you save varies by lender, they’ll typically cut your rate by 0.25% for every point. For example, your rate might start at 3.25% and drop to 3% after buying 1 point.

How do you figure out if you’ll save money by refinancing?

Let’s take a look at one example to see if refinancing would save you money, using an online mortgage calculator to crunch the numbers. In this scenario, let’s say you took out a $200,000 mortgage in 2017. It’s a 30-year loan with a 4% fixed interest rate, and you made a down payment of 20%. Your monthly payment is $1,064.

Step 1: Shop around for quotes and upfront costs

Three years into your mortgage, you’re ready to refinance—so you compare quotes among multiple lenders and find a good deal. The lender quotes you a 3% interest rate on a new 30-year loan. You’ll have to pay $8,000 in upfront costs:

• $5,000 in closing costs
• $2,000 for one discount point
• $1,000 for an upfront adverse market fee

Step 2: Calculate your monthly payment

With the new loan terms, your monthly payment falls to $938, saving you $126 a month. Divide your upfront costs by your monthly savings to see how long it will take to recoup those costs: $8,000 / $126 = about 63 months, or just over 5 years.

Another option is refinancing to a 15-year mortgage. Although you wouldn’t save on the monthly payment—it would increase to $1,306 per month in this scenario—you save money by paying less interest over time.

Step 3: Calculate your interest savings

When deciding whether refinancing is best for your financial situation, you have a few options. Do the math to figure out which one best serves your needs.

• Keep your original loan. If you pay down your original mortgage over 30 years, the interest would ultimately cost $115,280. If you use the closing costs you have on hand to put toward your current loan, you'll shave off a bit more.
• Refinance with a 30-year mortgage. With a new 30-year loan at a 3% interest rate, you pay $78,589 in interest over 30 years—but you also need to account for the interest you’ve already paid on the original loan: $18,194. Add those together to come up with your total interest cost: $96,783. This total could decrease further if instead of pocketing the monthly savings, you put it toward the principal instead.
• Refi to a 15-year loan. Taking out a new 15-year mortgage drives up your monthly payment, but your total interest costs drop to $32,634. Add your original loan interest ($18,194) to get your total interest cost: $50,828.

Step 4: Make the call

It’s time to figure out whether you’d like to gain a little more wiggle room in your monthly budget, pay off the loan faster, or stick to your original loan. Ask yourself these questions to figure out if a refi is worthwhile:

• How long do I plan to stay in the home? A refinance may save you money if you’ll be in the home for the long term. But if you’re moving soon, then you lose money because you won’t recoup the upfront costs. Remember, in the above example, it would take more than five years to make up for the expenses. So, depending on your situation, it might not make sense to refinance at all.
• Can I increase my monthly payment? If you have extra room in your budget for a higher payment, then refinancing into a 15-year loan term can help you save more on interest.
• How much do I need to save? Refinancing takes some time, effort, and money. You’ll need to figure out whether the amount you’re saving is worth the trouble. “If you’re only saving $20 a month and you make $100,000 a year, maybe it’s not worth the effort for you to go through,” says Mike Tassone, co-founder and chief operating officer of Own Up. On the other hand, if you’re financially struggling, then maybe any savings will help.

You saved money by refinancing—now what?

Don’t let your monthly mortgage savings burn a hole in your pocket. Instead of going on a shopping spree every month, you can direct the money toward other expenses. Here are some ideas:

Pay down your mortgage faster

If getting out of debt is important to you, then you might decide to take your monthly savings and pay down your mortgage faster. In the example above, you save $126 a month. Adding that to your new monthly payment would help you pay off your mortgage seven years earlier. Plus, you’d save another $39,000 in interest.

Pay down your other debts

Instead of targeting your mortgage, you could take your monthly savings and pay down your other debts. Here's a bonus benefit: When you pay down loan and credit card balances, your credit utilization drops—which may help you boost your credit score.

Build your emergency fund

Of course, this could also be a great time to build your emergency fund if you don’t have three to six months’ worth of monthly expenses saved yet.

While it’s fine to use the savings to splurge every once in a while, the main idea is to do something that will help you get financially ahead.

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