Laura answers a listener's question about how to know if it's better to refinance a high-interest mortgage or to prepay it over time.
Laura answers a listener's question about how to know if it's better to refinance a high-interest mortgage or to prepay it over time.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Natalie W., who says:
"I took out a 30-year mortgage for $773,000 at 7.18% interest to build a new home. But my current home has no mortgage and should bring about $500,000 when I sell it. I'm considering a refinance but am worried about paying too much for closing costs. Should I refinance the new home loan or pay it down with the $500,000 proceeds and send an extra $2,000 monthly?"
Thanks for your question, Natalie! When you're a homeowner, your mortgage payment is likely your largest monthly expense, so it's wise to consider reducing it and your interest expense by refinancing. This post will review how to know when a mortgage refinance is right for your situation.
Thanks for downloading episode 913 of the Money Girl podcast! I'm Laura Adams, an award-winning author, money speaker, on-camera spokesperson, and founder of The Money Stack, a free Substack newsletter.
You can learn more and connect with me at LauraDAdams.com. That's also where you can email your money question, learn more about my books and courses, and sign up for The Money Stack. You can also record a brief question or comment on our voicemail line at 302-364-0308.
What is a mortgage refinance?
Refinancing is a common transaction in which a borrower takes out a new loan to pay off an existing one. The new debt could be with your same lender or a different institution. The most common reason to refinance is when you can get a lower interest rate, which decreases the interest you must pay and perhaps your monthly payments.
When you take out a mortgage to buy or build a home, various factors determine the interest rate you get offered. While your credit, down payment, and income history are critical, lenders base mortgages on prevailing interest rates, which fluctuate.
The Freddie Mac website shows historical data for interest rates on 30-year mortgages since 1971. In January 2021, a fixed-rate, 30-year mortgage was 2.65% on average. In October 2023, the same loan was 7.8%; in March 2025, the going rate is 6.6%.
Since rates change periodically, your mortgage may significantly differ from the rate you could qualify for today. However, a good rule of thumb is to refinance only when the current rate dips at least one percentage point below what you're paying.
READ ALSO: The right time to pay off your mortgage
What does a mortgage refinance cost?
A percentage point spread between your existing loan interest rate and a new one should be at least a percentage because, as Natalie mentioned, there's a cost to refinancing. She's wise to be concerned that the closing costs could be too high.
Closing a loan means paying fees to various companies, including your lender or mortgage broker, property appraiser, closing agent or attorney, and surveyor. Plus, there are fees required by the local government for recording the mortgage and more costs, depending on where you live.
The total upfront cost of a refinance depends on the lender and property location. It could be as high as 3% to 6% of your outstanding loan balance. The trick to knowing if it's worth it is to figure out when you'd break even on those costs.
You'll lose money if you pay for a refinance but don't keep your home long enough to recoup the total costs. But if you own the property beyond the financial breakeven point (BEP), you'll save money in the long run by doing a mortgage refinance.
You may be able to roll closing costs for a refinance into the new loan, which means you would have nothing or little to pay out-of-pocket. However, adding them increases the amount you borrow and may also increase the interest rate you pay for the life of the loan. For that reason, be cautious about financing the costs of a refinance and carefully compare your options.
Factors in a BEP calculation depend on various factors, including your:
However, you can use the following quick BEP formula to get a general idea of whether a refinance would be worthwhile for you.
Refinance breakeven point = Total closing costs / Monthly savings.
For instance, if your closing costs are $5,000 and you save $150 a month on your mortgage payment by refinancing, it would take 34 months or almost three years to recoup the cost. The calculation is $5,000 total costs / $150 monthly savings = 33.3 months to break even.
For help crunching your numbers, check out the Refinance Breakeven Calculator at dinkytown.com.
How do I qualify for a mortgage refinance?
If you believe doing a refinance could be wise, you must also consider whether you qualify. Lenders have different underwriting requirements, but most require you to have a minimum amount of equity in your property.
Equity is the difference between your home's market value today and what you owe on it. A critical ratio for refinancing is known as the loan-to-value or LTV. For example, if your home value is $300,000 and you have a $150,000 mortgage outstanding, you have $150,000 in equity, an LTV ratio of 50%. But if you owed $250,000, that would be an LTV of 83%.
You typically need an LTV of less than 80% to qualify for a mortgage refinance. Lenders may still work with you if you have a high LTV and good credit, but they may charge a higher interest rate.
If you have an existing FHA or VA mortgage, you may qualify for a "streamlined" refinance program that requires less paperwork and less equity than a conventional refinance. Check out the FHA Refinance program and the VA Refinance program to learn more.
RELATED: How can I pay off my mortgage early?
7 situations when refinancing a mortgage makes sense
Here are five scenarios when a mortgage refinance may be a good money move.
1. You could get a lower interest rate.
If you're like Natalie and got a mortgage when rates were higher than now, you may be a good candidate for refinancing. However, as mentioned, you should carefully research the cost and BEP.
2. You have an adjustable-rate mortgage (ARM).
Buying a home with an adjustable-rate mortgage has many advantages, like a lower rate and monthly payment. That can make qualifying for a larger loan easier than a fixed-rate mortgage.
With an ARM, your monthly payments get smaller when interest rates decrease. But when ARM rates go up, your mortgage payment increases. There are caps on annual increases, but your rate could double within just a few years if rates have a significant spike.
Instead of worrying about how high your adjustable-rate payment could go, you might refinance to a fixed-rate loan. That move would lock in a reasonable rate that can never change, making it easier to manage money and stick to a budget.
3. You don't plan on moving for several years.
Once you know what a refinance will cost, be sure you'll own your home long enough to pass the BEP, or you'll lose money. For most homeowners, it typically takes owning your home for at least three years after a refinance to make it worthwhile.
4. You have enough home equity.
As I mentioned, you typically need at least 20% equity to qualify for a refinance. If you have less, you may still find lenders that will work with you. However, unless your credit is excellent, you'll typically pay a higher interest rate when you have low equity.
Also, if you don't have 20% equity, lenders charge private mortgage insurance (PMI). Adding that to your new loan could cut your savings and give you a longer breakeven point.
5. Your finances are in good shape.
The higher your income and credit, and the lower your debt, the better your refinancing terms will be. If you're unemployed or your credit took a dive due to a hardship, wait until your financial situation has improved before making a mortgage application. Good credit can save thousands in mortgage interest.
6. You need to change a co-borrower.
Refinancing is one solution if you want to remove a co-borrower, such as an ex-spouse or partner, from your mortgage. However, if one borrower doesn't have sufficient income and credit to qualify for a refinance, your best option may be to sell the property instead of refinancing.
7. You want to tap home equity.
You may qualify for a cash-out refinance if you have ample home equity. That allows you to get a larger loan than your existing mortgage, so you walk away from the closing with cash.
RELATED: Pros and cons of a home equity line of credit (HELOC)
Should I prepay my mortgage or refinance?
Knowing when to refinance your mortgage or keep it and make one or more additional payments depends on your financial situation and goals. Since Natalie is building a home, let's assume she plans to stay there for at least several years, which is essential for making a refinance pay off.
Another consideration for prepaying or refinancing a mortgage is how long you've had it. Refinancing starts your new loan on day one. That wouldn't be a downside for Natalie because she recently got her new construction loan.
However, if you only had ten years remaining on a 30-year mortgage, starting over with another 30-year mortgage may not save enough interest to be worthwhile. With a fixed-rate mortgage that amortizes, the total monthly payment is the same, but the portion allocated to interest is higher in the early years and lower in the later years.
Refinancing doesn't make sense when the going mortgage rate is too high to generate savings. Natalie said her rate is 7.18%, and the 30-year fixed rate mortgage, as of this podcast, is 6.6%. Therefore, I recommend waiting to refinance until rates drop a percentage point to 6.18% or lower.
If rates don't decline enough, paying extra on your mortgage principal as a lump sum or monthly amounts could be a better way for Natalie to reduce her long-term interest costs and pay off the loan faster. She could always prepay her mortgage with a lump sum or monthly payments and refinance later if rates drop.
However, prepaying a mortgage is only wise when your finances are in excellent shape. Natalie didn't mention her situation, such as whether her retirement investments are on track or if she has other debt. But since she can afford to pay an extra $2,000 monthly for her mortgage, I'll assume her finances are solid.
To learn more about the pros and cons of paying off a mortgage early, check out podcast 836, Should I Invest Extra Money or Pay Down My Mortgage?, and 774, How to Know When to Invest or Prepay Debt.
If you decide to refinance a mortgage, maximize your savings by comparing rates with multiple lenders. Interest rates can vary by half a percent or more, adding up to a significant difference in your monthly payments and long-term savings. Sometimes, your current lender may be willing to waive specific fees if services like your title search, survey, or appraisal are less than six to twelve months old.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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