Refinancing Explained

Rates have dropped. Everyone is telling you to refinance. The question that actually matters is not whether rates are lower than your current rate -- it is how long it takes to recoup the closing costs of the new loan through monthly savings. When to refinance your mortgage has nothing to do with how much rates have dropped. It has everything to do with one calculation: the break-even point.

What Refinancing Actually Does

Refinancing replaces your existing mortgage with a new one. The new loan pays off the old loan, and you start making payments on the new terms. You can refinance to get a lower rate, change your loan term, switch from an adjustable rate to a fixed rate, or pull equity out as cash.

Every refinance has closing costs -- typically $4,000 to $8,000 depending on your lender and loan size. Those costs exist whether or not you realize it. Some lenders roll them into the loan balance or cover them with a higher rate. Either way, you pay them.

Three Types of Refinancing

• Rate-and-term refinance: You keep the same loan balance but change the rate, the term, or both. The most common type. You are simply getting better terms on the money you already borrowed.
• Cash-out refinance: You borrow more than you currently owe and receive the difference as cash, based on your home equity. You are increasing your loan balance. Home improvements that add value can make this a sound trade. Using it to fund a vacation is a different conversation.
• Streamline refinance: A reduced-documentation option available for FHA and VA loans. Faster and cheaper than a full refinance, but limited to rate reduction. No cash out available.

The Break-Even Calculation -- the Only Number That Matters

Before refinancing, run this math:

• Current loan: $350,000 remaining at 7.5%, monthly P&I of $2,447
• New loan at 7.0%, monthly P&I of $2,329
• Monthly savings: $118
• Refinance closing costs: $6,000
• Break-even: $6,000 divided by $118 equals about 51 months, or roughly 4.25 years

Stay in the home past 4.25 years and refinancing saves you money. Sell or refinance again before that and you spent $6,000 for nothing. The break-even is the decision. Everything else is noise.

When Refinancing Makes Clear Financial Sense

• You can lower your rate by 0.5 percent or more and the break-even lands within your expected ownership window
• Your credit has improved significantly since the original loan and you now qualify for a meaningfully better rate
• You want to switch from an adjustable-rate mortgage to a fixed rate before potential rate increases
• You want to shorten your term from 30 years to 15 years and can absorb the higher monthly payment
• You want to access home equity for a purpose that justifies increasing your loan balance

When Refinancing Does Not Make Sense

• You are within five to seven years of paying off the loan -- most of your payment is now principal, not interest, so the savings are minimal
• You plan to sell the home within two to three years and will not reach break-even
• Rates dropped only marginally below your current rate and closing costs are high relative to monthly savings
• Your credit score declined since the original loan and you no longer qualify for the same rate tier

Shopping a Refinance Is the Same Process as the Purchase

The savings from comparing competing refinance offers are just as real as when you bought the home. Get at least three quotes from different lenders on the same day. Compare APR, total closing costs, and the break-even calculation on each offer before deciding. The lender who did your original loan does not automatically deserve the refinance.