Refinancing a Mortgage

A refinance replaces your mortgage with a new one. Done at the right moment it can cut the cost of the largest debt most households ever carry. Done for the wrong reason it can quietly add years of payments and thousands in fees while appearing to save money every month. This chapter shows how to tell the difference: the three numbers that decide whether a refinance pays, why a lower payment is not the same as a lower cost, the main kinds of refinance, and how to shop for one.

The three numbers that decide it

The rate gap. The difference between your current rate and the rate you can get now, for a loan with similar terms. Your credit score, the share of the home you own, and the loan size all affect the new rate, so a published average is only a starting point.

The closing costs. A refinance carries most of the costs of a purchase loan: origination charges, appraisal, title insurance, recording fees, and sometimes points paid to lower the rate. Together they often come to a few percent of the loan. They may be paid in cash, added to the new balance, or covered by accepting a slightly higher rate in exchange for a lender credit, but they are always paid somehow.

How long you will keep the loan. Savings arrive month by month; costs arrive at closing. The break-even point is the number of months it takes for the monthly saving to repay the closing costs. If you are likely to sell or refinance again before then, the refinance loses money.

A lower payment is not the same as a lower cost

Consider a household that owes $380,000 at 7.0% with 27 years left, and is offered a new 30-year loan at 6.0%.

The payment falls from $2,614 to $2,278 a month, a saving of about $335. If closing costs come to 3% of this balance, that saving takes about 34 months, close to three years, to repay them. That is the break-even.

But look at the total. The current loan has $466,838 of interest left to pay; the new one charges $440,185 over its life. The rate cut saves something, but the new loan also restarts the clock: three more years of payments, and most of the early payments go to interest again. Add the closing costs and the lifetime saving shrinks further.

There is a simple way to keep the rate cut without resetting the clock: take the new loan, but keep paying roughly what you paid before.

Paying $335 a month above the new required payment, close to the old payment, clears the new loan in 261 months, under 22 years, with $300,353 of interest in total. That is years sooner and far cheaper than the $466,838 left on the current loan, and the lower required payment stays available as a safety margin in a bad month. Most lenders accept extra principal payments without a penalty, but confirm that the new loan has no prepayment penalty.

A shorter term is the other route, if the budget allows it.

Fifteen-year loans usually carry a lower rate than thirty-year loans. Here the payment rises to $3,105, but total interest drops to $178,885. The trade-off is flexibility: the higher payment is required every month, while extra payments on a 30-year loan can be paused.

The main kinds of refinance

Rate-and-term. Changes the rate, the term or both, without taking cash out. This is the refinance the examples above describe, and the one the break-even test fits best.

Cash-out. Borrows more than you owe and pays you the difference. It is sometimes used to pay off credit cards at a much lower rate, or to fund a renovation. The risks are real: unsecured debt becomes debt secured by your home, the payoff is stretched over decades, cash-out loans usually carry a somewhat higher rate than a plain refinance, and lenders cap how much of the home's value you can borrow. If the spending that created the card balances continues, the household ends up with both a larger mortgage and new card debt.

Removing mortgage insurance. Private mortgage insurance on a conventional loan does not usually require a refinance to remove. Under the federal Homeowners Protection Act, you can ask the lender to cancel it once the balance reaches 80% of the home's original value, provided your payment record is good, and it must end automatically at 78% on the original schedule. Some lenders also accept a new appraisal showing the home has risen in value. FHA loans are different: for many FHA loans the insurance lasts as long as the loan, and refinancing into a conventional loan is the usual way to end it.

Adjustable to fixed. If an adjustable-rate loan is near the end of its fixed period, refinancing into a fixed rate trades some possible saving for certainty. Compare the fixed rate with the most your adjustable rate could reach under its caps, which your loan documents list.

Shopping and closing

Rates and fees differ between lenders for the same borrower, so comparison is worth the effort.

• Request Loan Estimates from several lenders on the same day, so they reflect the same market. The Loan Estimate is a standard three-page form that makes offers directly comparable. Credit scoring models treat several mortgage inquiries within a short window as one.
• Compare the APR and the lender's own charges, not just the rate. A low rate bought with points can cost more than a slightly higher rate without them if you do not keep the loan long enough.
• Ask about lender credits and fee reductions. Title insurance and other third-party services can often be shopped, and some lenders reduce title costs when the previous policy is recent.
• Lock the rate once you choose, and know when the lock expires.
• Read the Closing Disclosure, which must arrive at least three business days before closing, against your Loan Estimate. For most refinances of a main home, federal law then gives you three business days after signing to cancel.

On taxes: mortgage interest is deductible only if you itemize, on acquisition debt up to $750,000 for loans taken out after December 15, 2017. Cash taken out for purposes other than buying, building or improving the home generally does not count as acquisition debt. Points paid on a refinance are usually deducted over the life of the loan rather than in the year paid. IRS Publication 936 has the details.