Guidelines for When and How to Refinance a Home Loan

Need cash? You may want to get what’s called a cash-out refinance. Americans had more than $18 trillion in home equity in 2019,¹ about one-third of which is considered to be “tappable equity” (in other words, not already loaned as part of a mortgage and not more than 80% of the home’s value). In that situation, a home loan refinance can produce cash for the homeowner. A closely watched index called the Mortgage Monitor recently showed that 45 million mortgage holders could tap into an average of $140,000 each.² You could be in a position to refinance if you’re in that group—and if the math works out for you.

Want to lower the interest rate on your home loan? You could do what’s called a rate-and-term refinance. Average interest rates on conventional fixed-rate home loans dropped below 4% in 2019 and have been trending downward for decades, from a high of 18.5% in October 1981.³ If your current home loan carries a higher interest rate than what’s available today, refinancing could save you money—again, if the math works out.

Whether you want a cash-out or rate-and-term refinancing, several details will be important to your refinance calculations. Actual costs and interest rates vary across time, location, lender, borrower, and type of loan. Many of the differences may seem slight—a fraction of a percent here or there—but the annual compounding of interest or the spreading of loan costs over time can make a difference of thousands of dollars in the total cost of a loan. Luckily, there are many loan calculators online that can help.

A cash-out refinance involves replacing your existing mortgage with a new one whose amount is higher than what you currently owe, which is how you come away with cash in hand. This type of home loan competes with home equity lines of credit (HELOCs) and personal loans that are secured by using your house as collateral.⁴ People usually do cash-out refinancing when they want to make a home improvement, consolidate debt, or cover other large expenses or investments. More than 8 in 10 refinance loans were cash-out loans in 2019, according to official statistics.⁵

If you’re one of those homeowners with tappable equity, you still have to analyze whether a cash-out refinance is a good move. “Nearly half of tappable equity holders have current first [mortgage] rates of 4.25% or higher, making cash-out refinance an attractive option for those wishing to access the equity in their homes,” according to the Mortgage Monitor. The other half would find it harder if not impossible to make the case for a cash-out refinance.

Experts also cite a number of factors that drive up the costs associated with cash-out home mortgage refinancing in ways you might not expect. Cash-out loans may come with added fees, points, or a higher interest rate because they pose higher risk to the lender.⁶ Some experts estimate that 3-6% of the loan will be needed for closing costs, such as origination and appraisal fees,⁷ where typical closing costs amount to 2-5%.⁸ As with most loans, the size of your new mortgage could also carry an increased interest rate, if it’s particularly large or small. And the longer the payment schedule, the higher the interest rate.⁹

Remember, too, that there are associated risks. You could lose your collateral—your house—if you cannot keep up your payments. If housing prices drop, you could end up “under water,” with a loan that’s higher than your property value. Cash-out refinancing can also lower your credit score, but only temporarily, if you make payments on time.¹⁰

Rate-and-term refinancing has a lot in common with cash-out refinancing, except that it’s about saving money rather than raising money. Technically, you get a new mortgage with a lower interest rate and/or shorter repayment schedule, to lower the total cost of your mortgage.

Home refinancing interest rates may vary from rates for purchasing a home. While I was researching this article, for example, I found one big bank advertising lower rates for refinancing than for purchasing (by 0.1% on a 30-year fixed-rate home loan). Another advertised the reverse (higher for a refinance, by about the same amount). Typically, however, loan rates are personalized, via online applications and in-person discussions.

In personalizing, lenders can factor in things like:

• Your credit score
• Debt-to-income ratio
• Your home’s loan-to-value ratio (the amount of your loan as a percent of your home’s market value)
• Even how many months’ worth of expenses you have in savings¹¹ 

As with the cash-out home refinancing, seemingly small differences in fees and interest rates can make a big difference here, too. By one calculation, someone holding a 30-year mortgage for $240,000 with a 4.25% interest rate could pay $10,000 less, over the life of the loan, than someone with a 4% interest rate.¹²

But timing is everything, as the old saying goes. How long have you had your current mortgage? How much longer will you be staying in your home? Where are interest rates today, and where are they heading tomorrow?

These calculations (and others) will determine whether refinancing is cost effective for you—and how much you could save. In a rate-and-term refinance, for instance, whether you achieve enough savings to cover your costs will depend on how long you remain in your home (and hold the loan). In addition, if you’ve had your current mortgage for a long time, you may be at the point where you’re more rapidly paying down principal. Getting a new mortgage means “resetting the clock” back to year one, in which most of each monthly payment applies to interest. One rule of thumb: If your mortgage is only in its early years, and you can lower your rate by 0.75% or more, it might be worth considering. ¹³