When mortgage rates fall, refinancing can seem like an easy way to lower your monthly payment. But a lower payment doesn’t necessarily mean you’ll save money over the life of the loan.
Before refinancing, it’s important to look beyond the new interest rate and consider closing costs, loan term, your remaining mortgage balance, tax considerations and how long you expect to stay in your home.
Is There Really Such a Thing as a No-Cost Refinance?
Be cautious when you see advertisements for a “no-cost” refinance. Refinancing generally involves expenses, even when a lender doesn’t require you to pay them upfront.
Those costs may be covered through lender credits, added to your loan balance or offset by accepting a higher interest rate. In other words, you may not pay the costs out of pocket, but that doesn’t necessarily mean they’re free.
Common Mortgage Refinancing Costs
The costs associated with refinancing vary by lender, loan type and individual circumstances. Potential expenses include:
- Origination fees. Lenders may charge a fee for processing and originating the new mortgage.
- Discount points. Points are prepaid interest paid at closing in exchange for a lower interest rate. One point generally equals 1% of the loan amount.
- Prepaid interest. Depending on your closing date, you may need to prepay interest for the remainder of the month.
- Escrow costs. Your lender may require funds for property taxes and homeowners insurance to be deposited into an escrow account.
- Other closing costs. Depending on the transaction, you may also encounter appraisal, credit report, title, legal, recording and other fees. Certain loans may also involve mortgage insurance or other loan-specific charges.
Not every refinance includes all of these costs, so ask your lender for a detailed estimate before making a decision.
Calculate Your Refinancing Break-Even Point
One of the simplest ways to evaluate a refinance is to estimate your break-even point.
For example, if refinancing costs $6,000 and reduces your monthly payment by $300:
$6,000 ÷ $300 = 20 months
You would need to remain in the home for roughly 20 months just to recover those refinancing costs through monthly payment savings.
However, this calculation is only a starting point. It doesn’t account for changes in the loan term, total interest paid or other costs associated with the new mortgage.
Consider the New Loan Term
A lower monthly payment isn’t necessarily a better deal.
For example, refinancing a mortgage with 20 years remaining into a new 30-year loan could reduce your monthly payment but extend the time you’ll be paying interest. Depending on the interest rate and loan balance, you could ultimately pay more interest over the life of the new loan.
When comparing refinancing options, look at both:
- Your new monthly payment
- The total cost of the new loan
Also consider how long you expect to remain in the home.
Don’t Overlook the Tax Impact
Refinancing can affect the amount of mortgage interest you pay and, depending on your circumstances, the tax benefits associated with that interest.
The tax treatment of refinance points and mortgage interest depends on factors such as how the loan proceeds are used and whether you itemize deductions. For example, refinance points generally are deducted over the life of the loan rather than entirely in the year of refinancing, subject to applicable rules and exceptions.
Because everyone’s tax situation is different, it’s worth discussing the potential tax impact with your tax advisor before refinancing.
What About a Cash-Out Refinance?
A cash-out refinance allows you to borrow more than you currently owe and use some of your home equity for other purposes.
While this can provide access to cash, it also increases your mortgage balance and potentially your long-term borrowing costs.
If you’re considering a cash-out refinance, evaluate the cost of the additional borrowing separately from the potential savings of refinancing your existing mortgage.
Check Your Existing Mortgage First
Before refinancing, review the terms of your current mortgage. Depending on your loan, you may have a prepayment penalty or other costs associated with paying it off early.
You should also compare the new loan’s interest rate, fees, repayment term and total projected interest—not just the monthly payment.
Is Refinancing Right for You?
There isn’t a single interest-rate difference that makes refinancing worthwhile for everyone. The right decision depends on your mortgage balance, current rate, proposed new rate, closing costs, loan term, tax situation and how long you expect to stay in the home.
Before moving forward, compare the total financial impact of the new loan rather than focusing solely on the monthly payment.
If you’re considering refinancing, your tax advisor can help you evaluate the potential tax consequences and how the decision fits into your broader financial goals.