What Is Refinancing?
Refinancing replaces an existing loan with a new one, usually at a lower interest rate or better terms. Learn when refinancing makes sense and the costs involved.
Definition
Refinancing is the process of replacing an existing loan with a new loan that has different terms -- typically a lower interest rate, different loan length, or different monthly payment. The most common type is mortgage refinancing, but you can also refinance auto loans, student loans, and personal loans. The new loan pays off the old one, and you begin making payments on the new loan.
There are two main types of mortgage refinancing: rate-and-term refinance (you change the rate and/or length of the loan without taking cash out) and cash-out refinance (you borrow more than you owe and receive the difference in cash, using your home equity). Rate-and-term refinances lower your payments. Cash-out refinances give you access to your home's equity but increase your total debt.
Refinancing is not free. Closing costs typically run 2-5% of the loan amount ($6,000-$15,000 on a $300,000 mortgage). This means you need to save enough through the lower rate to recoup the closing costs before refinancing makes financial sense. The "break-even point" is how long it takes to recover those costs through monthly savings.
Real-World Example
You have a $250,000 mortgage at 7.5% with 25 years remaining. Monthly payment: $1,849. You refinance to 6.0% for a new 25-year term. New payment: $1,611. Monthly savings: $238. Closing costs: $7,500. Break-even point: $7,500 / $238 = 31.5 months. If you plan to stay in the house for at least 3 years, refinancing saves you money. Over the remaining 25 years, you save about $63,900 in total interest.
Why It Matters
Refinancing can save tens or even hundreds of thousands of dollars over the life of a loan. When interest rates drop 0.75-1.0% or more below your current rate, it is worth running the numbers. But refinancing only makes sense if you plan to stay in the home long enough to recoup closing costs. Refinancing every time rates drop slightly can actually cost you money when closing costs are factored in.
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Frequently Asked Questions
When should I refinance my mortgage?
The general rule of thumb is to refinance when you can lower your rate by at least 0.75-1.0% AND you plan to stay in the home long enough to recover closing costs. Calculate your break-even point (closing costs divided by monthly savings) to be sure.
What are the costs of refinancing?
Closing costs typically run 2-5% of the loan amount. On a $300,000 mortgage, expect $6,000-$15,000. Some lenders offer 'no-closing-cost' refinances but compensate with a slightly higher rate.
Does refinancing hurt your credit score?
Temporarily, yes. The hard inquiry can lower your score by 5-10 points, and opening a new account reduces your average account age. But the impact is usually minor and recovers within a few months.
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