Refinancing replaces your current mortgage with a new loan, often to lower your interest rate, shorten your loan term or lock in a fixed rate. Some homeowners also choose a cash-out refinance, which lets you tap your home’s equity and receive a lump sum for larger expenses.
As housing markets shift and personal finances evolve, many homeowners periodically reassess whether their mortgage still fits their needs. Changes in income, home equity, debt levels or long-term plans can all create opportunities, or reasons to consider refinancing.
Still, refinancing isn’t automatically a win. Closing costs, extended loan terms and aggressive lender offers can quietly add thousands of dollars to your total cost. Before you apply, it’s important to understand the warning signs, run the numbers and make sure a refinance truly aligns with your financial goals.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
Warning signs and red flags to watch for
Refinancing can be financially smart, but not every offer is created equal. Some lenders rely on confusing terms, aggressive marketing or hidden costs that can quietly increase what you’ll pay over time.
Be aware of warning signs and red flags that you might see when refinancing a mortgage:
- Too-good-to-be-true offers: If a refinance offer seems to be too good to be true, it probably is. Look out for aggressive pitches and offers designed to be irresistible, such as unbelievably low interest rates.
- No closing costs: Refinancing comes with closing costs, but some offers roll those costs into the loan amount, increasing your debt and the amount you’ll pay in interest. “No closing cost” offers should be reviewed carefully.
- Upfront fees: Most lenders won’t require you to pay any large fees upfront when refinancing a mortgage; you’ll just be responsible for closing costs at the closing. If the loan terms outline upfront fees, you may not be working with a legitimate lender.
- Excessive pressure: Refinancing a mortgage is a big decision, and you should take your time researching lenders before you decide to refinance. If a lender or broker is pressuring you to quickly decide to refinance, walk away.
Do the math: Rates, costs and break-even
(Image credit: Getty Images)
Refinancing your home can help you get a lower interest rate, but you’ll also need to pay closing costs. Calculating your break-even point, which is the point at which your interest savings will cover the closing costs, can help you determine whether refinancing makes sense.
To get started, add up all of your closing costs, including lender fees, title costs and escrow services. You’ll also need to determine how much your new mortgage will save you per month; you can do that by subtracting your new monthly mortgage payment from your old monthly mortgage payment.
To calculate your break-even point, divide your total closing costs by your monthly savings. The resulting figure is the number of months that it will take before your savings will cover the closing costs and you’ll break even.
For example, if your closing costs are $6,000, and you’ll save $250 per month, it will take 24 months before you break even on your refinancing.
A common rule of thumb can help you decide when to refinance. If you have a 30-year mortgage, a 0.75% drop in interest rates will usually result in positive savings after three years, often justifying the cost of refinancing. With a 1% drop, you’ll break even in about 20 months.
Generally speaking, if interest rates have dropped by 0.5% or less, refinancing may not be worth it, since you won’t reach your break-even point in a reasonable amount of time.
When you refinance, you have the option to extend the loan term, taking a longer time to pay down your mortgage. Extending the loan term on a 30-year refinance could end up costing you more over time, since it starts amortization over again.
When you start paying on your new 30-year mortgage, your initial payments are interest-heavy, which increases your cost. Even if you have a lower interest rate, the longer mortgage term and interest could mean you’ll ultimately pay more. To avoid this scenario, consider refinancing while maintaining your loan term or even shortening your mortgage to a 15-year term if you can comfortably afford the payments.
Other financial traps you might overlook
Even if you avoid obvious red flags, refinancing can still come with less visible costs that affect your long-term finances. Understanding these potential traps can help you make a more informed decision.
Be aware of several other refinancing traps that could cost you money:
- Closing costs: Refinancing closing costs can range from 2% to 6% of your total loan amount, on average. If you have a $400,000 mortgage, your closing costs could be $8,000 to $24,000. Make sure that you understand these costs before you close on your refinance.
- New loan terms: Your new loan terms could delay your payoff or increase your mortgage’s lifetime interest. Carefully read the refinance terms and make sure you understand how they will impact your mortgage going forward.
- Mortgage insurance and equity requirements: If you refinance with less than 20% equity on a conventional loan, you’ll typically need to pay private mortgage insurance until you rebuild sufficient equity, which increases your monthly costs.
How to shop and compare refinance offers
Different lenders offer different terms and interest rates, so it’s important to shop around and compare quotes from different lenders. Request at least three quotes from different lenders and pay attention to factors like interest rates, closing costs and loan terms.
Consider getting offers from credit unions, online lenders and mortgage brokers, since they may offer lower interest rates and better overall terms than larger traditional banks and lenders.
Who should not refinance right now
Refinancing can offer benefits to some homeowners, but make sure that it makes sense for your specific situation. For example, if your refinance break-even point is in five years, but you plan to move within the next two years, refinancing doesn’t make financial sense, and you’ll pay more to refinance than you’ll save. Think about how long you plan to stay in your home to determine if you should refinance now.
You also need sufficient equity in your home to be able to refinance. According to A+ Federal Credit Union, you’ll generally need at least 20% equity in your home. Some lenders will work with you if you have less equity, but chances are you’ll need to pay private mortgage insurance until you build up 20% equity again, which adds onto the cost of refinancing and pushes your break-even point further out.
If you don’t have a strong credit score, refinancing may not make sense, either. Lenders often consider borrowers with poor credit scores as being higher risk, so they charge a higher interest rate to make up for that risk. If you’re refinancing to take advantage of a lower interest rate, you may not qualify for that interest rate, especially if your credit score has dropped since you initially bought your home.
Practical next steps before you apply
Before you apply to refinance a mortgage, do some calculations to determine if it makes financial sense. The Navy Federal Credit Union’s mortgage refinance calculator makes it easy to see how much refinancing could save or cost you.
Take some time to talk with a trusted financial adviser or mortgage professional about your goals and what you should consider when refinancing. These experts can provide advice tailored to your specific situation and can also help you spot potential financial pitfalls.
Curious about today’s refinance interest rates? Use the tool below, powered by Bankrate, to explore and compare some of today’s top offers: