The Basics of Mortgage Refinancing
Maybe you’re not exactly sure what refinancing means. Let’s get into the nuts and bolts of how the mortgage refinance process works.
What is refinancing a home?
Refinancing means that you pay off your existing mortgage using money from a new mortgage, usually with better terms. The purpose is to help you achieve a financial goal, such as saving on interest, reducing your monthly payment, changing your loan term, or borrowing cash to cover major expenses.
How does refinancing work?
Using an example, let’s say you borrowed $400,000 at a 4% interest rate and are repaying it over 30 years. Several years after you took out that mortgage, you’ve paid down your principal balance to $375,000, interest rates have dropped, and your credit score has increased. You refinance your mortgage at a 3.5% interest rate with the same 30-year term, which lowers your monthly payment as you have less interest to pay. The trade-off is that your loan term starts over, and you’ll be making payments longer to repay your new mortgage.
That’s just one of many different approaches you can take with refinancing. If you’re looking to shorten the length of your term and pay off your mortgage more quickly, you can refinance from a 30-year loan into a 15-year loan. You’ll likely pay less in interest but face a higher monthly mortgage payment.
You also could tap into your home’s equity and borrow cash at a lower interest rate by refinancing for a larger mortgage. Equity is the difference between what your house is worth and how much you owe on it. Over time, equity grows if the value of your home appreciates and you pay down the mortgage principal. You can use the cash from refinancing for any purpose, but you must repay it as part of your new mortgage. Many homeowners use this money to fund home improvements or other major expenses, pay for college, or retire high-interest debts like credit cards.
How long does it take to refinance a mortgage?
Refinancing generally takes about 30 to 45 days, but it can vary. If your finances are complicated, the underwriter may need more time to verify your income and assets before approving you for the new loan. It’s also possible that issues with the home inspection or appraisal can delay the refinancing process.
When Should You Consider Refinancing a Home?
A mortgage refinance can affect you in several ways, so you should think through whether refinancing makes sense for your financial situation and goals.
“The general rule is to consider refinancing when you see interest rates 1% lower than what you currently pay,” says Rashalon Hayes, assistant vice president of field mortgage at Navy Federal Credit Union in Vienna, Virginia.
A key area to understand is your break-even point, which is how long it will take for your savings from a lower interest rate or smaller monthly payment to recoup the costs of refinancing. Keep in mind that it generally takes at least a year before you hit your break-even point and begin saving money. You can use our free mortgage refinance calculator to get a sense of your potential savings.
“A good rule of thumb for a borrower when considering a refinance is if they can save at least one-eighth of a percent on loans over $500,000 and one-fourth of a percent on loans below that, and cover all closing costs within one year,” says Peter Boomer, executive vice president and head of mortgage distribution at PNC Bank in Hinsdale, Illinois.
Reasons To Refinance Your Home
If any of the following scenarios apply, then you may benefit from refinancing your mortgage:
- Interest rates have dropped. If interest rates are significantly lower than when you took out your current mortgage, you can refinance and save money each month. However, this could result in a higher total loan cost if you don’t refinance with a shorter term.
- Your credit has improved. If you’ve consistently paid off debt since you first took out your mortgage, then your credit score may have increased. A stronger credit score can help you get a lower interest rate and save money.
- You want to reduce your monthly payment. If you can lock in a better interest rate, then you may be able to lower your monthly mortgage payment. Again, keep in mind that you could end up paying more interest if you extend the loan term.
- You can repay your loan more quickly. If you refinance to shorten your loan term, then you’ll finish repaying your mortgage sooner and pay less in total interest. Expect this to increase your monthly payment, so be sure you can afford it.
- You’re rethinking your adjustable-rate mortgage. An ARM allows the interest rate on the mortgage to change throughout the loan term. Refinancing to a fixed-rate mortgage makes your monthly payment more predictable.
- You have enough equity and want additional cash. If you do a cash-out refinance, you can tap into your home’s equity to address your debts, pay for home renovations, and more.
Reasons Not To Refinance Your Home
Here are some instances where it might not be worth refinancing your mortgage:
- Your credit score has dropped. Your credit score helps determine the interest rate you can get, which in turn affects your monthly payments and the total cost of your loan. If your credit has worsened since you bought your home, then it will be difficult to refinance with better terms.
- The value of your home has decreased. In ideal circumstances, your home appreciates in value as you maintain and improve it. But if the fair market value of your home has fallen for reasons outside of your control, then you might not be able to get a better deal by refinancing.
- You know you’re moving soon. If you’re planning to relocate in the next few years, there might not be enough time for you to reach the break-even point and recoup the costs of refinancing.
- You haven’t built enough equity. “If you just moved into your home and don’t have much equity established yet, you may not get the best interest rate on offer,” Hayes says.
- Your loan has a prepayment penalty. Some lenders charge a penalty for repaying a mortgage ahead of schedule. Check your loan terms to find out if your current home loan includes a prepayment penalty.
- You would be extending your loan term. You can refinance to lower your interest rate and monthly mortgage payment, but this may result in a longer loan term — which means you’ll likely pay more interest overall.
Home Refinancing Costs To Consider
Refinancing comes with closing costs, just like your current mortgage. Closing costs on a refinance average about $5,000, according to Freddie Mac.
Though this list isn’t exhaustive, here are some common closing costs you can expect to pay when refinancing:
- Appraisal fee: An appraisal determines how much your home is worth and the amount you can borrow, and is typically required by lenders. This service usually costs around $300 to $500.
- Discount points: Points are upfront charges that can help you get a lower interest rate. The cost will depend on how much your lender charges, as well as how many points you choose to buy.
- Loan origination fee: Your lender charges a fee to set up your loan and cover the cost of underwriting, which is the process of verifying that you’re able to repay your mortgage. This fee typically runs 0.5% to 1% of the loan amount.
- Private mortgage insurance: If you’re taking out a conventional loan and your down payment is less than 20%, then you will need to purchase PMI, which protects the lender if you default on your mortgage. PMI costs roughly $30 to $70 per month for every $100,000 in your loan.
- Title search fee: This covers the cost of a title search, which reveals any existing claims on the home, such as unpaid taxes. A title search generally costs between $75 and $200.
How To Refinance a House in 5 Steps
Refinancing is a lot like getting a mortgage for the first time. Here are five steps you can expect to take.
1. Prepare your finances
Developing a big-picture view of your current situation will give you a better idea of how you may benefit from refinancing. Get ready to evaluate your finances and prepare certain documents for lenders.
Check your credit score and DTI
Before you refinance, you’ll want to find out if your credit score has changed since you took out your original mortgage. If your credit score has increased, it can help you receive a better deal when refinancing. If your score has decreased, then you may find it difficult to get favorable terms.
Lenders also will be looking at your debt-to-income ratio, which is calculated by dividing your total monthly debt payments by your gross monthly income. You typically need a DTI ratio of 43% or lower. This number demonstrates that you can afford to pay the mortgage and your other debts, and still have money left for essential expenses like food, utilities, and transportation.
Gather financial documents
To refinance your mortgage, expect the lender to ask you for:
- Bank account statements.
- Loan statements.
- Pay stubs.
- Proof of homeowners insurance coverage.
- Retirement and investment account statements.
- Tax returns.
- W-2 forms.
- 1099 forms.
Depending on your specific situation, additional documents may be necessary.
2. Know your home’s equity
It’s important to get a handle on your equity, especially if you’re doing a cash-out refinance. Equity is calculated by subtracting the amount you still owe on your loan from the home’s fair market value.
Say you bought your home for $400,000 with a 20% down payment, meaning the amount you borrowed was $320,000. Several years later, you’ve paid that down to $250,000, and the value of your home has increased to $450,000 — giving you $200,000 in equity. You could refinance for as much as 80% of the home’s current value, which would be $360,000. After you repay the $250,000 owed on your original mortgage, you’d have $110,000 in cash left over. Of course, that money isn’t free — you repay it as part of your new mortgage, though the interest rate is usually lower than you could get elsewhere.
3. Compare mortgage lenders
You don’t have to refinance with the same lender. By shopping around, you can make sure you’re getting a competitive interest rate. As you compare mortgage refinance lenders, be sure to note factors beyond price, including how quickly the lender responds to questions and its quality of service.
“It’s also important to work with a lender you can trust — one that understands your financial goals and will answer your questions openly and honestly,” Hayes says.
4. Prepare for the appraisal
Even though you had the house appraised when you bought it, you’ll likely need another appraisal to refinance. It helps the lender verify that your new mortgage matches the home’s current value. You might not need a second appraisal, however, if you have a loan backed by the Federal Housing Administration, the Department of Veterans Affairs, or the Department of Agriculture, as those agencies offer a streamlined refinancing process for FHA loans, VA loans, and USDA loans, respectively.
5. Submit your paperwork and close on the loan
After you’ve turned in all the paperwork, underwriting begins. The underwriter will examine your credit history, income, employment, savings, and debts. This process can take longer if your financial situation is complicated, but getting your paperwork ready in advance helps make it easier.
Tips for Refinancing Your Mortgage
Here are some pointers for navigating the mortgage refinance process:
- Map out how long you’re planning to stay. You could relocate for work, school, or other reasons in the not-so-distant future. “It may not make sense to refinance if the homeowner believes they are going to move in less than two years,” Boomer says.
- Consider your loan term and what you can afford. The most common loan terms are 30-year and 15-year terms, though some lenders allow you to pick a custom term. Think about whether it’s worth making higher monthly payments with a shorter term in exchange for paying less interest overall.
- Research your lender carefully. Your refinance may extend your loan term, so you want to make sure you’re committing to a lender that you like. “Always work with a reputable lender who can advise the best path to follow and guide you through the process,” Boomer says.
Mortgage Refinancing FAQ
Still have questions about refinancing? Let’s break down some commonly asked topics.
Not necessarily. While you can begin another 30-year term, you may be able to refinance with a shorter loan term. Just make sure that you can still afford the monthly mortgage payments.
No. Taking advantage of your equity to invest in renovations can increase your home’s value, but you aren’t required to put the money you get back into your house. You could use it to pay off other debts, cover unexpected bills, or do something else. Learn more about cash-out refinance.
Some lenders offer a no-closing-cost refinance, which lets you avoid paying the closing costs upfront. But that doesn’t mean they disappear. The closing costs are added to your principal, or you pay a higher interest rate to cover them.