I’ve been through several mortgage ^[2] refinances. My last refinance was to replace my adjustable rate loan with a 30 year loan and along the way, I was able to reduce my interest rate and payment. Refinancing is basically just the process of replacing an existing mortgage ^[2] with a new one.

Why should you refinance your mortgage?

1. To cut your costs. If interest rates have dropped significantly since you got your mortgage ^[2], refinancing will probably decrease your monthly payment and give your budget ^[3] some relief. You’ll also potentially reduce the amount of interest you pay over the term of the loan.
2. To change your type of loan. This was my motivation for refinancing. I had an 7 year ARM loan at 5 percent with a 7 year balloon payment. When rates dropped below that, I was able to leverage my good credit score ^[4] to get a 30 year loan at 4.75 percent. If you already have a 30-year fixed rate mortgage ^[2], you might refinance to get a 15-year, which would allow you to pay off the loan sooner and reduce the total amount of interest that you pay.
3. To pull some cash out. If you refinance and get a loan that exceeds your previous loan balance, you’ll receive a cash “refund” equal to the difference between your previous loan balance and the new loan balance. You can spend that money in any way that you wish, though lenders sometimes penalize borrowers who refinance for this reason by charging higher rates for the new loan. “Cashing out” isn’t the best idea but if you need some cash for starting a business, it might be okay. Taking a cash out to buy a car means you’re buying a car with a 5 – 10 year life and paying for it over 30 years. Not the best idea.

Should You Refinance Your Mortgage?

One quick rule of thumb recommended by experts in deciding whether to refinance is the 2 percent rule. It says that refinancing is worthwhile only if you can get a new loan with a rate at least 2 percent lower than your current rate. Of course, if you’re contemplating a mortgage ^[2] refinance to change your loan type, the interest rate may not be as large a factor.

Get Up To FIVE Mortgage Quotes In FIVE Minutes With LendingTree. ^[5]

Though the 2% rule is handy, it’s not definitive. A more thorough approach is to calculate how long it would take for the monthly after-tax savings that you’d receive from a new loan to cover your refinancing costs (typically equivalent to the closing costs of your original loan). To make that calculation:

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1. Calculate your monthly pretax savings, the difference between your current payment and your new payment. For this example, assume a current payment of $1,264.14 (a $200,000, 30-year fixed loan with an APR of 6.5 percent) and a new payment of $1,073.64 (the same loan with an APR of 5 percent). So the monthly pretax savings would amount to $1,264.14 – $1,073.64 , or $190.49.
2. Calculate your monthly after-tax savings. To do so, multiply your pretax savings by (1 – your federal income tax bracket). For this example, assume a tax bracket of 28 percent, which means you’d multiply $190.49 by (1 – 0.28), which equals $137.15. Yes, I know you don’t pay 28% on all your income but I’m trying to keep things simple.
3. Divide the amount of your refinancing costs (let’s assume $3,000) by your monthly after-tax savings. For this example, you’d divide $3,000 by $137.15 and get 22. This result is the number of months it’d take for your after-tax savings to pay back your refinancing costs. Only after this point does your refinancing begin to save you money.

By the 2 percent rule, you should not refinance in this situation, since the difference between the rates of the current loan and the new one is only 1.5 percent. But the more precise after-tax savings calculation shows that if you intend to keep the new loan for more than 22 months, it does make sense to refinance.

Tax Deductions for Refinancing Costs

Thought there are some significant tax advantages associated with refinancing your home ^[7], unlike closing costs on your original mortgage, you can’t write off refinancing costs on your taxes all at once. You can still deduct these costs, but your deductions must be spread out over the life of the loan, which means you’ll reap those tax savings only gradually and in small amounts.

Refinancing can make a lot of sense

Under the right circumstances, refinancing your mortgage can make a lot of financial sense, especially if you use a mortgage lender with low interest rates and you can get a lower interest rate.

About the author

Ron has written 1082 articles on The Wisdom Journal.

The founder and editor of The Wisdom Journal ^[8] in 2007, Ron has worked in banking, distribution, retail, and upper management for companies ranging in size from small startups to multi-billion dollar corporations. He graduated Suma Cum Laude from a top MBA program and currently is a partner in a national building materials company.

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