Refinancing your mortgage means replacing your existing mortgage with a new one. Your new mortgage pays off the original loan, and then you are responsible for paying off the new one.

But when is this actually a good idea, and worth the extra effort and cost?

Reasons to Consider Refinancing

There are a few reasons you may be thinking about refinancing your mortgage. You’re probably looking to save money in some way, but there are a few different ways you might accomplish that.

These are the main reasons you may want to refinance.

1. You can get a lower interest rate.

This is probably the most common reason you might consider refinancing. If you can get a lower rate, then you’ll lower the amount you pay on your mortgage. You’ll lower your monthly payments, which leaves you with more money in your pocket for other things.

This could happen if interest rates have fallen across the board. Or it could happen if your credit score has increased significantly since you first took out your mortgage.

2. You want to change the length of your loan.

Perhaps you want to switch from a 30-year mortgage to a 15-year mortgage. This would increase your monthly payments but reduce the total interest you pay and help you gain equity faster. It may help you be disciplined with your money by forcing you to put down more toward your house payments.

Or you could be in a 15-year mortgage and want to change to a 30-year mortgage. This will lower your monthly payments and give you more money to put toward other things. But if you are going to do this, it should be for good reason.

There are some cases where a 30-year mortgage is better, but only if you are very disciplined with your money. Lowering your monthly payments just so you can spend more on things you don’t need is a bad idea.

So I don’t recommend lengthening your mortgage term in most cases.

3. You want to change the type of mortgage.

You may have an adjustable-rate mortgage and want to replace it with a fixed-rate mortgage. A fixed-rate mortgage will lower your risk by locking in an interest rate for the length of the loan.

You probably shouldn’t do this the other way around, though. Adjustable-rate mortgages carry higher risk as interest rates often increase over the years.

So unless you are confident in lower interest rates, or you plan on moving in just a few years, don’t switch to an adjustable-rate mortgage.

Influencing Factors

The following factors can influence whether it’s financially worth it to refinance.

Your Credit Score

The better your credit score, the better interest rate you can qualify for. If your credit score has improved significantly since you took out your original mortgage, then you may be able to save a good deal of money by refinancing because you’ll qualify for a much better rate.

But if your credit score has gone down since your first mortgage, then it may not be worth it to refinance at this time. You should probably hold off and perhaps focus on improving your rating before pursuing refinancing options.

Closing costs

This is the big one that can really eat into the cost savings of refinancing your mortgage. Just like you had with your first mortgage, you will have closing costs. Your closing costs will vary depending on your location and home. But you can probably expect them to total about 2 or 3 percent of your total loan amount. Closing costs may include:

• Application fee
• Document preparation fee
• Home appraisal fee
• Title search and insurance
• Flood certification fee
• Inspection fee
• Recording fee
• Origination fee
• Attorney fee

That’s a lot of fees, and they will add up to a few thousand dollars. So it’s essential to consider this in the evaluation of whether it’s worth refinancing your mortgage.

Your home equity

Equity is the value of your home that you actually own. The lower your balance on the mortgage, or the higher your home value, then the more equity you have.

Generally it’s better to refinance if you’re in the first few years of your loan, because that’s when the majority of your monthly payment goes toward interest. If you’ve already paid off most of the interest on the loan, then you don’t stand to gain as much from a better interest rate.

On the other hand, if the value of your home has gone up, you can cash out your equity when refinancing. This means that you get the difference between the two home valuations in cash when you get the new mortgage.

But cashing out is dangerous and should really only be done in absolute emergencies, or if you have high-interest debt equal to that amount. Otherwise you’ll likely end up with a higher loan balance and less equity in your home - a bad financial combination.

How much longer you plan to be in your home

If you don’t plan on being in your home much longer, then you won’t have much time to recoup the closing costs associated with refinancing. You may want to calculate your breakeven point. The simplest way to do this is to divide your closing costs by the amount you save each month.

For example, say you save $100 each month and have closing costs of $2,000. It will take you 20 months to break even. So if you’re planning to move very soon, then don’t refinance. Of course, that doesn’t account for the time value of money, but it’s a close-enough approximation. In general, if you plan to move in 2 or 3 years, it’s not going to be worth it to refinance.

Estimating Whether It’s Worth It

As with most things in the money world, it depends on your specific situation. Sometimes it’s a good idea to refinance and other times it’s not.

If you know your specific costs, you can use this calculator to estimate whether you will save money by refinancing.

Moving Forward

Ultimately, there are a lot of considerations that go into whether it’s a good idea to refinance. How much money you save is really the big question, but many factors can add to or subtract from that number.

The biggest considerations are probably how much lower an interest rate you can get, and how much your closing costs will be.

I provided a calculator to help you visualize whether it may be worth it to refinance. A lot of times it’s not worth the hassle. But other times you can save a lot by doing it.

If you’re ready to take the next step, or if you just want to explore your options further, check out a couple of the best places to go for refinancing a mortgage.