Mortgage Refinance 101 - a Plain English Guide to Lowering the Cost of your Mortgage

2021-08-25T18:06:46.303Z

By Sean Hundtofte

Looking for answers on whether you should refinance your mortgage? Mortgage refinance is one of the more complicated types of debt transactions. We (US households) are notoriously bad at refinancing mortgages when we can, and also bad at shopping for the lowest price when we do. We end up leaving lots of money on the table (up to $10k dollars between the cheapest and most expensive lenders for the same product/person on any given day!). However, when done right, refinancing has many benefits including a great way to lower your overall debt. Here is a quick and easy guide to understanding your mortgage and when you should refinance. We’ve also automated all the math and shopping for you with our Mortgage Refinance Calculator

Should I refinance my mortgage?

Your two basic options. Either a) keep paying on your old home loan, or b) take out a new loan. Refinancing into a lower rate means a lower monthly payment, and lowering your monthly payment is your incentive to refinance. After you find out what refinance rates are for your particular situation, you have to do some complicated math to calculate whether the up-front costs and your time are worth the reduction you can get in monthly payment and account for future opportunities to refinance and lower those costs further (for more details see the geek-out section on research below).

How is refinancing different from my original mortgage?

The price (rates and dollar costs) of a mortgage and process for taking out a new mortgage is different when you already have an old mortgage on a home. First, the origination and closing costs for a new refinance are a little lower, e.g. you might not need an appraisal. But more importantly, you can usually find much lower prices for refinance “rate-term” mortgages (mortgages that lower your monthly payment)-- so long as you don’t increase the loan amount and take additional money out by tapping into your home equity that is.

What’s the most important thing to look for in a mortgage refinance?

You should be looking for the lowest cost dependable lender - where the price of a mortgage to you is a combination of rate and up front costs (“points”/”credits”, lender fees, and third party fees)! Once you’ve got the best price you can find online or offline, you have a choice of whether to take a loan out with the lowest cost lender you found or go back to your existing lender (as it’s probably unlikely they were the lowest price, but if so congratulations!). Often, mortgage lenders (and their servicers) are quite interested in recapturing you as a customer and might have a program for you. This may involve a little negotiation so call your existing lender (or loan servicer) with the price you found elsewhere and explain what you’re looking to do, asking them to match.

What other prices or variables should I be aware of?

The price for your mortgage is not just a rate. It also involves closing costs (fees, other costs), which you need to take into consideration before moving forward with a refinance decision. Even if there’s an option with a lower rate, that does not mean you should take that option. Take into considerations additional fees like closing costs, tax shield of interests, and other fees.

The tax shield benefit of the interest you pay on a mortgage (and some funkiness around the points you can pay to lower the rate) means any actual difference is smaller than it appears, as what you should care about are the dollars you have in your pocket to spend, i.e. post-tax dollars. Then there’s closing costs including lender fees. There’s the amount of time left on your existing mortgage or when you’d expect to move on and sell your home. All of these have to more than outweigh the reduction in monthly payment and they have to outweigh the likelihood that rates decline further and you could have saved even more money. That’s the financial component.Note that lenders charge vastly different prices for a new mortgage, especially once you take closing costs including lender fees into account. Even if it’s the right time for you to refinance your mortgage, the difference in prices between lenders often mean differences as high as +/-0.5% in rates (on loans with similar upfront costs/fees) between the highest and lowest priced mortgages in the market for you.

One thing we don’t keep track of in our calculator is the cost of your time. So we indicate when it’s a close answer and the effective savings are small, in case your time is precious.

When are rates low enough to make refinancing the right thing to do? Should I wait for rates to go lower?

You shouldn’t try to time the market unless you’re an active interest rate trader or researcher at a hedge fund or bank and have some private information. It might be that rates don’t make sense for you to refinance today, in which case we can take that problem off your hands and monitor them for you. Market volatility makes this hard and painful to track perfectly on your own, so we’ve created a tool that alerts you when the timing is right and can notify you when it is.

What if I want to refinance just to reduce my debt and improve my credit?

If refinancing for purely rate or improvement in credit score reasons, the type of loan you want is a “rate term” refinance mortgage. It’s called rate-term as it changes the rate as well as the term or date in the future when the mortgage will be paid off. If you increase your loan amount and effectively take cash out of your home, it is called a “cash out” refinance mortgage, where the rates might be as much as a percentage point (1%) higher.

Can refinancing help my credit score?

Yes - but the effects vary over time. Initially, just because you’re taking out a new loan there are small mechanical negative effects on FICO. This short-term impact should be made up for over the long-run by the improvement in your credit profile and additional safety cushion you get from lowering the monthly payment on your biggest debt (having more income left over every month). So long as you do not immediately use that extra buffer to take on new debts, you’ll have more of a safety cushion in savings in the future.

Where should I start?

You can use our refinance calculator to find the lowest rate and best overall option for you. We’ll do the shopping for you. We scan the internet for the latest pricing and the lowest dependable cost mortgage for your exact situation. Our calculator uses actual prices from lenders, giving you an actionable recommendation.

What makes “computer assisted borrowing” (or a roboadvisor for debt) great?

Our Mortgage Refinance Calculator takes care of the timing. We model interest rate volatility and figure out optimal option exercise. What this “financial AI” does for you is to maximize your expected savings, taking the friction to refinancing (of those closing costs) into account. So you don’t have to do a PhD in Finance!

Can I trust lenders that I find online?

In our experience, online prices and online lenders are often the cheapest for mortgages. Online lenders tend to be more digital and have lower costs to manufacture a loan, which makes sense (e.g a staff report from the NY Fed on technology in lending). What this just means to you, is if you would prefer to borrow from an offline lender, you should do your shopping online first, and then go to the offline lender with a firm price quote or - even better - a loan estimate (LE) from the online lender. Not all lenders advertise their prices online. If they don’t, you can be pretty sure they aren’t trying to compete on price. The difference between the cheapest and most expensive mortgage for the same person on any given day on average is about $10k (at the closing table - not savings over time)! So you need to pull all the data and do the math or let someone you trust do it for you.

For the Geeks: What is a mortgage “prepayment” for Models of Optimal Exercise? What is Price Dispersion?

Investors (and Academics) call refinancing your mortgage “prepayment”. Your ability to do so is your prepayment option: you have the option to buy back your debt at ‘par’, like owning the call to buy a stock at a certain price. And because predicting cashflows is pretty important to figuring out the value of an investment, both the research teams on trading desks at big banks and mortgage/finance researchers at Universities have spent a few decades - since mortgages become liquidly traded in capital markets in the 1980s -studying and modeling the exercise of this option. A lot of the difficulty in modeling has actually come from the fact that we (humans) are so bad at perfectly and voluntarily refinancing fixed rate mortgages, compared to when a perfect computer version of a finance professor would do it. We’re hoping to do our bit to change that.

Examples of relevant research here in case you’re interested are: Agarwal, Rosen, and Yao (2014) and Agarwal, Driscoll, and Laibson (2017) Regardless of the exact approach, the main theme of any prepayment model is the same: there are some upfront costs (closing costs) the borrower (that’s you) has to incur in order to prepay their mortgage, in return for locking in some savings over time. In some bright future of digital mortgages, those fixed costs will get close to zero and we’ll have automated refinancing for you, but until then we have to run the numbers and take costs into account.

The reason lenders can afford to charge such different prices is because we (US households) are notoriously bad at shopping for mortgages (Bhutta, Fuster, and Hizmo 2019, including research our own Sean Hundtofte did at the New York Federal Reserve). Taking out a mortgage is typically an infrequent activity; and in terms of complexity, UI, and lack of experience it might not be surprising that most people throw their hands up or stop at the first price a friendly broker or loan officer gave them. We (borrowers) do a bad job of keeping lenders honest.

Use our refinance calculator to find the lowest rate and best overall option for you today.

By Sean Hundtofte

Read previous

Solve Finance FAQ

Read next

How to figure out the best mortgage for your personal situation and goals