Mortgage rates continue to creep along at historically low levels, as the pandemic continues to generate economic headwinds. Low rates are good news for anyone looking to buy a home — but if you already have a mortgage, rates like these also make it an excellent time to consider refinancing.

What is refinancing?

When you refinance, you pay off your existing mortgage with a new home loan that comes with new rates and terms. If you secured your existing mortgage when interest rates were higher than they are today, refinancing at a lower rate can reduce your monthly payment or allow you to pay off the loan faster (and sometimes both).

Reasons to consider refinancing

There are many valid reasons to refinance. 

Common scenarios include:

• Reducing your monthly payments: Switching to a new loan with a lower interest rate can reduce your monthly mortgage payment. The amount you’ll save each month depends on the size of your mortgage and how much lower the new interest rate is compared to your previous loan. You can use a loan calculator to estimate your new monthly payment.
• Paying off your mortgage sooner: If your original mortgage was a 30-year loan, you could refinance to pay it off sooner. With a lower interest rate, you may be able to switch to a 15-year loan and still have a manageable monthly payment. Reducing the length of the mortgage also lowers the total amount of interest you’ll pay over the life of the loan.
• Getting cash out of your home: With a cash-out refinance, you apply for a new loan that’s larger than what you owe on your old loan — and take the difference as a cash payment. Many homeowners use a cash-out refinance to pay for home improvements.
• Switching to a fixed-rate loan: If you have an adjustable-rate mortgage, switching to a fixed-rate loan could be a good move. Refinancing can help you reduce future risk, according to Jason Fink, a professor of finance at James Madison University in Harrisonburg, Virginia. Locking in a fixed rate provides both predictability and protection from future rate increases.
• Eliminating private mortgage insurance: Most loans require private mortgage insurance if you put less than 20% down when buying a home. Because home prices in many areas have increased, you may have recently crossed the 20% equity threshold, creating an opportunity for you to refinance without PMI, which could further reduce your monthly payment.

When refinancing doesn’t make sense

While lower monthly mortgage payments sound enticing, refinancing isn’t always a smart financial move.

Although refinancing can save you money, it can also come with hefty upfront fees. Since a refinancing loan is a new home loan, you’ll have to pay closing costs just like you did for your original mortgage. Those fees range between 3% to 6% of the loan amount — or $9,000 to $18,000 for a $300,000 refinance, for example.

A refinance may have fixed fees or variable costs that depend on the size of your loan. According to Fink, refinancing is still worthwhile — even if you have a large loan balance — because reducing your interest rate can save you tens of thousands of dollars in interest over the long term.

Keep in mind, it could take a few years to recoup your refinance fees. If you expect to move in a few years, the trouble and expense of refinancing now might not make sense.

Refinancing also may not be worth it if you’ve owned your home for a long time. Mortgages are designed so that your highest interest payments come during the early years. The longer you’ve had the mortgage, the more your monthly payment goes to paying off the principal. If you refinance later in the loan term, you’ll revert to primarily paying interest instead of building equity.

What factors determine my refinance rate?

Several factors determine the refinance rate you’ll pay. One of the most important factors is your credit score; people with lower credit scores may pay a higher interest rate than someone with a better score.

The length of the loan also affects your refinance rate. A 30-year note will have a higher rate than a 15-year mortgage. Fink suggests finding a lender who will offer a “float down” provision, which can help you take advantage of subsequent rate drops — even after you’ve locked in. 

For example, if your rate is locked in for 30 days and rates drop within that time period, you’ll be able to lock in at the lower rate. A float down option will cost you — typically 0.5% to 1% of the loan amount — but it could save you money if rates drop. 

“You usually have to opt in to the lower rate, so be sure you pay attention to daily rate changes,” Fink said.

What credit score do I need to refinance?

Your credit score will be a factor in your refi options, as will the type of home loan you’re pursuing. A conventional loan, for example, usually requires a credit score of 620 or higher.

You may qualify for a Federal Housing Administration refinance with a credit score of 580, however. And if you already have an FHA mortgage, you may qualify for a streamline refinance that requires less credit documentation.

If you’re hoping to refinance to lock in a lower rate, a high credit score will put you in a better position. Typically, the higher your credit score, the lower your rate. If your credit rating is too low, consider delaying your refinance application while you work to improve your credit score. 

You can improve your score by:

• Making on-time debt payments: Get up to date on any payments you’re behind on and create a plan to pay all your bills on time. Take advantage of automatic payments to ensure you’re never late paying credit cards or loans again.
• Limiting purchases you put on your credit card: Lenders prefer that you use no more than 30% of your available credit, so don’t max out any of your cards. Pay down any balances so they’re less than 30% of your credit limit.
• Fixing any errors on your credit report: Contact the credit bureau about incorrect information, such as debts you’ve paid off that are listed as unpaid. The bureau must fix incorrect entries on your report, but it can’t eliminate negative entries that are accurate.

Compare refinance rates

Even though rates are low right now, it’s a good idea to shop around and research different mortgage lenders before refinancing your home loan. Be sure you understand all of the up-front fees and use a mortgage calculator to help you determine how much you’ll be expected to pay at the time of closing. It’s also important to calculate how much you could save by refinancing into a shorter loan term, if you want to maximize your savings.