Homeowners with a high interest rate on their mortgage may benefit from refinancing their home. Refinancing is when you trade in your old mortgage for a new one with a lower interest rate. For some, this could result in lower mortgage payments and savings on interest costs.
However, refinancing a mortgage isn’t free. Homeowners must pay closing costs for the new loan, which on average were $3,398 including taxes in 2020. If your closing costs are more than what you could save in interest costs over the term of your loan, then refinancing might not be a good idea.
How Are Refinancing Costs Calculated?
Typically, refinancing costs are based on the amount of your mortgage. The bigger the mortgage, the more the closing costs might be. On average, you can expect the total cost to refinance a mortgage to be around 1-3% of the loan total.
That 1-3% breaks down into some of the most common refinancing costs homeowners encounter:
- Application fee: Usually, this is a few hundred dollars, but it can vary depending on the lender.
- Appraisal fee: An appraisal is when a licensed appraiser comes to your home to assess its market value. A lender may want this estimated home value to know that the loan on the home is justified.
- Attorney or title company fee: A real estate attorney or title company can assist with paperwork and represent your best interests when it comes to your loan. They can also make sure your first mortgage is completely paid off to avoid any issues. They typically charge for these services at an hourly rate or a flat rate, depending on the loan complexity.
- Government taxes: Some states charge a tax to document your loan transaction. States like Pennsylvania or New York have an average of over $4,000 in taxes on a typical refinance. On the other hand, states like New Mexico and Connecticut don’t charge any taxes.
- Title search and insurance: Some lenders do require a title search before refinancing, even though homeowners likely had one for their first mortgage. This is an in-depth search to make sure your property doesn’t have any claims or liens on it and that you’re the legal owner, but the title insurance adds additional protection just in case.
Why Refinance Your Mortgage?
The main benefit of refinancing a mortgage is the chance to lower the loan’s interest rate. If interest rates have dropped since the homeowner took out their mortgage, getting a new loan with a lower rate could save thousands over the course of their loan.
For example, a homeowner may have bought a house in 2018 and locked in an interest rate of 4.54% for a 30-year term. In 2021, interest rates dropped significantly, so that homeowner was able to secure a new rate of 2.96% over a 30-year term. On a $300,000 mortgage, that could result in saving about $350 a month and saving $73,200 over the life of the new loan compared to the old one.
Refinancing could also be helpful for those who want to pay off their other debts. If you choose a cash-out refinance, you can use the equity you’ve built up in your home to pay off some of your bills. As an example, consider a home that’s worth $300,000. If a homeowner has $100,000 left on their mortgage, they would have $200,000 in home equity. Most lenders allow a cash-out refinance on 80% of the home market value, so the new loan would be $240,000. This lets the homeowner walk away after closing with $140,000 so their debts can be paid or used to their liking.
What You’ll Need to Refinance
Homeowners must first get pre-approved before going through the refinancing process. Many lenders require a minimum credit score, though that exact score varies by lender and loan type. Generally, a score below 580 may make it more difficult to find a lender willing to pre-approve you for a loan.
Lenders also typically require the following documents for a refinancing application:
- W-2s and 1099s for the past two years
- Tax returns from the last two years
- Employment history
- Last 30 days of pay stubs
- Last two months’ bank statements
Those who do not meet the eligibility to refinance with a conventional loan still have a few other options. An FHA refinance loan is a loan backed by the U.S. Department of Housing and Urban Development that typically permits a lower credit score and a lower interest rate.
Refinancing into a VA loan, which is backed by the U.S. Department of Veteran Affairs, is reserved for veterans, service members, and their surviving spouses. VA loans include better terms than conventional loans with some lenders allowing a cash-out refinance for up to 90% of the home’s market value.
Another option is an interest rate reduction refinance loan from the VA if a homeowner is seeking a lower interest rate and monthly payments.
Ways to Lower Your Refinancing Costs
There are several ways you can lower the costs to refinance your home, making the process even more affordable.
Improve Your Credit Score
One big way to lower the cost of refinancing is to work on improving your credit score. With a higher credit score, you may receive better refinancing options. Paying bills on time, reducing debt, keeping credit accounts open to show longer credit history, and avoiding hard credit pulls could all help to improve your credit score.
Ask for a Fee Waiver
While negotiating every closing cost is not feasible, your lender may consider waiving the application fee or providing you with a lender credit.
Shop for Better Rates and Costs
It could be beneficial to shop around for better interest rates. Some lenders may have lower interest rates or costs that could make switching worth the hassle. Comparison shopping for other services involved with your refinance, like home insurance providers or attorneys, could prove beneficial as well.
Think About a No-Closing-Cost Refinance
In this type of refinancing, the lender foots the bill for the closing costs upfront, meaning homeowners don’t have to pay them right away. Instead, the costs could be added to the principal balance or paid for in the form of a higher interest rate. However, despite the immediate reduced cost, this type of refinance could result in an overall higher long-term cost after factoring in the increased interest rate and principal.
When Is Refinancing a Bad Idea?
While many homeowners can benefit from refinancing, it’s not the best option for everyone. Here are some times when refinancing may not be a good idea:
- When closing costs are more than you can comfortably afford: If you don’t think you can afford the closing costs for a refinance, consider holding off. It could take years for you to break even on your refinance, which could result in more debt rather than savings.
- When you are planning to sell within the next 3-5 years: Refinancing helps save money in the long term. For the first few years, your lower monthly payments aren’t enough to outweigh the upfront closing costs paid. If you see yourself selling in a few years, that is not enough time to break even and reap the rewards of a lower interest rate.
- When the savings are not significantly better on the refinanced plan: Before refinancing, make sure it’s actually a better deal than your current mortgage. Use a refinance calculator to see how much you can save over the lifetime of your loan. If it turns out you may save only a few hundred dollars over the life of the loan, it probably isn’t worth all of the hassle to refinance.
Depending on the terms of your original mortgage, refinancing can be an excellent tool for reducing your monthly payment and overall interest costs. It’s also helpful if you want to cash in on what you’ve already paid to tackle other debts. That said, refinancing isn’t for everyone. In many cases, the costs to refinance a mortgage can outweigh the overall savings. Before committing to a refinance, make sure to consider all of the pros and cons of your individual situation to see if it’s right for you.