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“Should I refinance my mortgage?” is a common question among homeowners with mortgages — especially when interest rates are rising.

Refinancing your mortgage can lower your monthly payments, decrease the total amount you pay back, or even put some extra cash in your pocket — but it’s not for everyone.

Whether or not mortgage refinancing is right for you depends on market conditions, your goals, your credit score, and the type of mortgage loan for which you’re qualified.

Let’s take a closer look at how refinancing your mortgage works so that you can better gauge if mortgage refinancing is right for you.

What is a mortgage refinance?

Mortgage refinancing entails taking out a new mortgage to replace your current mortgage. The new mortgage loan allows you to pay off the remaining debt on your old mortgage; you can then pay back the new mortgage based on the new terms.

People often refinance their mortgages to take advantage of lower interest rates.

When should I refinance my mortgage?

There’s no cut-and-dried rule about when to refinance your mortgage. It depends on what you’re trying to achieve through the mortgage refinancing.

Some reasons that refinancing your mortgage might be good for you include:

  • Needing to increase monthly cash flow so you refinance your mortgage to lower your monthly mortgage payments
  • If you have more cash available each month and are looking for ways to save on overall mortgage costs
  • If you’re facing the end of the fixed-rate period of an adjustable-rate mortgage (ARM) or a balloon mortgage and want a fixed-rate mortgage refinance that locks you back into consistent, predictable monthly mortgage payments
  • If you’re looking to use a mortgage refinance to cash out some of your home’s equity and pay for something big

Identifying your goals in a mortgage refinance will help you make the right choice for your particular situation.

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Types of mortgage refinancing loans

Borrowers can usually choose between two types of mortgage refinancing loans.

  • Rate-and-term mortgage refinance: This type of mortgage refinancing swaps out your existing mortgage for a new mortgage with a different interest rate and term (the time period over which you repay the mortgage loan).

Here’s an example that shows the benefits of a rate-and-term mortgage refinance:

Ten years ago, Florence took out a $200,000 30-year fixed-rate mortgage at a 6% interest rate, on a home valued at $270,000 at the time. She’s consistently made the monthly mortgage payments — about $1,200 — and still owes about $167,000. She has 20 years remaining on her mortgage.

Florence refinanced for a new 20-year mortgage for the remaining $167,000, this time with a 4.5% interest rate. Her new monthly mortgage payment is now about $1,060. Even taking into account the $2,000 in fees she paid for the new mortgage loan, she’ll pay nearly $35,000 less in total at the end of the 20 years than if she kept her original mortgage (assuming she’s planning to stay in her home that long).

  • Cash-out mortgage refinance: A cash-out mortgage refinance also involves paying off your existing mortgage with a new mortgage loan with a different rate and term. But with this type of mortgage loan, you refinance for more than you currently owe on your existing mortgage, and take the difference in cash. Typically, people use that “extra” money for home improvements. Some people use it to pay for their children’s college educations, consolidate debt, pay off big medical bills, or for other major expenses.

Your conventional cash-out mortgage refinance can’t be more than 80% of your home’s value (75% if it’s a second or investment home). Consider Irene, who owns a house valued at $200,000 and has $100,000 remaining on her current mortgage. She gets a cash-out mortgage refinance for $160,000, 80% of her home’s value and the maximum available to her. After she pays off her home’s current mortgage balance, she’s left with $60,000 in cash (she uses some of that to cover the closing costs on her mortgage refinancing, so she winds up with a few thousand dollars less).

Considerations before refinancing your mortgage

Lots of factors contribute to determining if mortgage refinancing is right for you, and also the type of mortgage refinancing for which you’re qualified. Among them are:

  • Repayment term: When you refinance your mortgage, you’re “starting over” with a new home mortgage loan with a new term. Keep in mind that a 30-year fixed-rate mortgage likely requires lower monthly mortgage payments than a 15-year one, but will cost you more overall, because your interest rate accrues that whole time.

If a mortgage refinancing interest rate is significantly lower than your current mortgage rate, you may be able to get a shorter term without affecting your monthly mortgage payments too much. This costs you less because you’ll save in total mortgage interest.

  • Break-even time: You’ll pay closing costs to refinance your mortgage, which can range from a few hundred to a few thousand dollars. The “break-even” time is how long it will take you to recoup those costs. In general, the bigger the interest rate reduction you achieve when refinancing your mortgage, the shorter the break-even time.

“The payback on the closing costs shouldn’t exceed 24 to 30 months” advised Robert E. Tait, a mortgage banker at Allied Mortgage Group.“The borrower should plan to stay in their home for at least 12 months longer than the payback period” to make a mortgage refinancing worth the costs involved.

If you refinance your mortgage into a loan with a shorter repayment term, your monthly mortgage payment may increase, but your break-even time will be shorter than if you reduce your monthly mortgage payment. That’s because you’re getting a better mortgage interest rate and paying your loan principal off faster. Estimating your break-even time can be tricky so look for a mortgage calculator that takes into account the relevant factors.

  • Credit score: “Ideally, a borrower should have a median FICO/credit score of 740 to secure the best rate in a mortgage refinance transaction,” said Tait. “If there is more than one borrower, lenders use the lowest median FICO/credit score of the borrowers for qualifying purposes.” If your credit score is less than 740, you may still qualify for mortgage refinancing but your interest rate may not be the best rate the lender offers.
  • Equity: Typically, you need at least 20% equity for a cash-out mortgage refinance and, in general, to refinance a conventional mortgage loan. This means that if your property is worth $300,000, you’d owe $240,000 or less on it.

Some lenders will refinance with less equity for a higher interest rate and if you buy mortgage insurance. Also, the government makes mortgage refinancing programs available to those with government-backed mortgages — such as FHA or VA loans — that may require little or no equity. Some mortgage loans also qualify for the Home Affordable Refinance Program (HARP), a government mortgage refinance program for people who owe as much or more than their homes are worth.

  • Mortgage closing costs: Some lenders offer a no-closing-cost mortgage refinancing option, meaning you don’t pay closing costs in one lump sum when you close on a new mortgage loan. Rather, lenders either raise your interest rate a little to waive those costs, say 3.9% rather than 3.5%, or the lender bakes those closing costs into the mortgage loan itself. Either way, you’ll end up owing a little more on your mortgage each month than if you paid those costs upfront.

A no-closing-cost mortgage refinance usually makes sense if you’re not planning on staying in your home very long — say less than five years — or you’ll refinance your mortgage again soon so that extra interest won’t affect you too much. You’ll need to crunch your financial numbers to see if a no-closing-cost mortgage refinance is the best option for you.

  • Mortgage pre-payment penalty: Your mortgage lender may charge a fee if you pay off your mortgage early by refinancing. Check with your mortgage lender if you’re unsure.
  • Tax implications of mortgage refinancing: If you are claiming the mortgage interest deduction on your existing mortgage, you should be aware of changes to the tax code taking effect in 2018 for new mortgages. It used to be that up to $1.1 million in mortgage debt qualified for the deduction, including up to $100,000 in home equity debt used for any purpose. For homeowners taking out new mortgage loans, that $1.1 million limit was decreased to $750,000. In addition, the interest you pay on a new cash-out mortgage refinance or home equity loan is only deductible if you use it to buy or make “substantial improvements” to your home.

You should always consult with a tax advisor if you have questions.

Related: How to Refinance Your Mortgage Step-by-Step

Is a home equity loan the same as a cash-out mortgage refinance?

Home equity loans or home equity lines of credit (HELOCs) are generally considered second mortgages. They are loans you take out on the equity you have in your home, on top of the primary mortgage you already have.

A cash-out mortgage refinance is not a second loan – it’s a new mortgage entirely that replaces your prior mortgage.

If you want to extract cash from your home, you’ll need to examine the pros and cons of a home equity loan versus a cash-out mortgage refinance in your particular situation.

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