What Is Mortgage Refinancing?
Mortgage refinancing is when a homeowner pays off their existing home loan with a new one that typically saves them money through a lower interest rate, a longer or shorter loan term, or a different loan type, or lets them borrow cash against their equity to pay for major expenses.
“If there is a reduction of the interest rate, term of the loan, or consolidation of other debt, it may be a good time to consider refinancing,” says James Orlando, president of Brooklyn MLS, a platform for real estate agents in New York City.
When you refinance, you’re applying for a new mortgage. That means you’ll need to apply for the new mortgage, let the lender verify your credit score and finances, get the home appraised, and — once the loan is underwritten and approved — pay closing costs.
Refinancing usually takes 30 to 45 days, though the exact timeline can vary based on your financial situation.
Why Refinance Your Mortgage?
Homeowners usually refinance to achieve a specific financial goal. Some of the more common reasons to refinance are:
- To reduce your loan’s interest rate. When market rates drop, refinancing can save you money on overall loan costs.
- To change your loan type. Refinancing lets you switch between an adjustable-rate mortgage and a fixed-rate mortgage to better suit your financial needs.
- To lower your monthly payment. Refinancing to a longer loan term or lower interest rate can reduce your monthly mortgage payment.
- To pay off your mortgage more quickly. Switching to a loan with a shorter term likely will increase your monthly payment, but could shave years off your repayment schedule and let you own your home free and clear sooner.
- To borrow home equity. A cash-out refinance lets you borrow the value you’ve accumulated in your home to pay major expenses or consolidate debts. You repay the cash you borrowed as part of your new mortgage.
Types of Mortgage Refinancing
There are several ways to refinance your mortgage, depending on your goals.
A rate-and-term refinance allows you to adjust your mortgage interest rate and loan term without borrowing cash against your equity. Sometimes known as a regular refinance, this method avoids increasing your mortgage balance, though you do have to pay closing costs.
Here are some reasons to get a rate-and-term refinance:
- You can secure a lower interest rate on your mortgage and save on the total interest paid on the loan.
- You can switch from an adjustable-rate mortgage to a fixed-rate mortgage to lock in your interest rate and monthly payment.
- You can own your home free and clear more quickly, and pay less interest on your loan, by shortening your loan term and increasing your monthly payment.
- You can reduce your monthly payment to make it more affordable by refinancing to a longer term, though you will pay more interest this way.
Here’s an example of how this might work. Let’s say you make a 10% down payment on a $500,000 home, and take out a 30-year fixed-rate mortgage for $450,000 at an 8% interest rate. With those terms, your monthly payment is $3,302, and you will pay $738,699 in interest over the life of the loan.
Eight years later, you’ve paid down your balance to $409,580 and paid $276,565 in interest to your lender. If your home’s value has increased to $650,000, and interest rates have come down to 6.5%, here’s how a rate-and-term refinance could play out:
- Refinancing your balance into a new 30-year fixed-rate loan would reduce your monthly payment to $2,589, saving you $713 a month. You’ll pay $522,397 in interest on the new loan, bringing the total interest paid to buy the home to $798,962. The cost of reducing your monthly payment is paying an extra $60,263 in interest — and eight more years of loan payments.
- Refinancing your balance into a new 15-year fixed-rate loan increases the monthly payment by $266 to $3,568. You’ll pay $232,639 in interest on the new loan, for $509,204 in total interest paid to buy the home. These terms will save you $229,495 in interest over your original loan, and you’ll pay off the loan seven years earlier.
Predicting costs with an ARM is tricky. Say you bought the same house with an ARM that had a 7% interest rate locked in for the first five years, and then the rate increased by a quarter percentage point each of the next three years. For the first five years, your monthly payment would be $2,994, and you’d pay $153,233 in interest and have a balance of $423,592. In the sixth year, your payment would increase to $3,062, in the seventh to $3,129, and in the eighth to $3,194.
Refinancing your balance of $404,757 into a 30-year fixed-rate loan at 8% interest would reduce your payment to $2,970 and keep it the same for the entire term. Refinancing from an ARM to a fixed-rate loan can save you money if interest rates increase, but also can cost you more if rates decrease. For many homeowners, having a fixed payment that won’t increase is reassuring — and you always can refinance again if interest rates drop enough to save you money.
With refinancing, you can tap into the equity you’ve built in your home and borrow it as cash. This is what’s known as a cash-out refinance.
Sticking with our example, if you’ve paid down your balance on a $450,000 fixed-rate loan after eight years to $409,580, your home’s value has increased to $650,000, and interest rates are 6.5%, you could borrow 80% of your home equity to take out $110,420 in cash and have the following repayment options:
- A 30-year fixed-rate refinance loan would give you a slightly lower monthly payment of $3,287, and you’d pay $939,796 in total interest — or $201,097 more than if you’d stuck with the original loan.
- A 15-year fixed-rate loan would cost you $4,530 a month and cost you $571,921 in interest for an overall savings of $166,778.
You may do whatever you want with the cash you borrow from your equity, though most financial advisors recommend against using it to pay for things like vacations or new cars that don’t increase in value over time. It’s more common for homeowners to use the cash to make repairs or improvements that increase their home’s value, pay off high-interest debts, or cover major expenses such as college tuition or medical bills.
When you refinance, you have to pay closing costs. Additionally, you must pay private mortgage insurance if you have less than 20% equity in your home after refinancing.
With a cash-in refinance, you make a lump-sum payment that allows you to replace your current home loan with a smaller one. This reduces your principal, can eliminate PMI, and lowers your monthly payment. Additionally, you may be able to get a better interest rate on the refinance by reducing your loan-to-value ratio.
For example, let’s say interest rates have dropped and you’ve inherited $30,000 from a relative. You might decide to use $20,000 of that inheritance to make a lump-sum payment on a cash-in refinance. In doing so, you reduce your remaining mortgage principal from $200,000 to $180,000. The interest rate on your original mortgage was 7.5%, but your interest rate on the new mortgage has been reduced to 6%. By replacing your mortgage with a smaller one that has a lower interest rate, your monthly payment goes from $2,592 to $2,117.
However, a cash-in refinance also comes with trade-offs. By putting cash into your home, it’s no longer liquid. You won’t have easy access to it, which means you may end up sidelining other important financial goals, or run the risk of not having enough to cover emergencies.
A streamline refinance is a rate-and-term refinance with a simplified approval process that often forgoes the credit check, income verification, or home appraisal.
This process is most common with government-backed mortgages:
- If you have a loan backed by the Federal Housing Administration, a streamline refinance can help lower your monthly payment and interest rate, even if you owe more than your home is worth. However, there are limitations. You can only take out $500 in cash, and you have to pay mortgage insurance.
- Veterans Affairs loans are offered to eligible military service members, veterans, and their surviving spouses. A VA interest rate reduction refinance loan — better known as an IRRRL — can help you lower your monthly payment or switch from an adjustable-rate mortgage to a fixed-rate mortgage.
- U.S. Department of Agriculture loans also offer a streamline refinance option, which can help existing borrowers refinance to a more affordable monthly payment. A new home appraisal and credit review aren’t required for a USDA streamline refinance.
When Should You Consider Refinancing a Home?
A mortgage refinance can have a major effect on your finances. It’s also not free — you need to pay closing costs. Refinancing should accomplish a major financial goal, such as reducing your interest rate, changing your loan type or term, or making your monthly payment more affordable.
“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 integrated member strategy at Navy Federal Credit Union in Vienna, Virginia.
A key concept to understand is the break-even point, which is how long it takes for your savings from a lower interest rate or smaller monthly payment to exceed the cost of refinancing. It usually takes at least a year before you hit your break-even point and begin saving money.
Be sure to run the numbers and think through whether refinancing makes sense for you. You can use our mortgage refinance calculator to get a sense of how much money you could save with a refinance.
How To Find the Best Refinance Rates
Here are some tips on how to find the best refinance rates:
- Consider the market. If interest rates have increased, then your new refinanced mortgage may also come with a higher rate.
- Use a refinance calculator. A refinance calculator can demonstrate how much you’ll save on your monthly payment with a lower interest rate.
- Calculate your break-even point. If your refinance closing costs are $8,000 and you’re monthly payment is being reduced by $400, then it will take you 20 months to break even.
- Compare different offers. Be sure to shop around and get refinance quotes from different lenders. They’ll all use the same loan estimate form, which makes it easier to compare offers.
Mortgage Refinancing Requirements
Here are some of the requirements that you’ll likely need to meet for a mortgage refinance:
- You have enough home equity. You can think of equity as the value of your home minus the amount you owe on it. To refinance, lenders often require at least 20% equity. If you don’t have that much, your lender may approve a refinance but might charge you a higher interest rate or require PMI.
- You’ve owned your home for at least six months. Before you can refinance, lenders often require you to own the home for a certain amount of time — especially if you’re looking to take cash out. Exact requirements vary by loan type and lender.
- Your credit score meets the minimum requirement. If you’re looking to refinance a conventional loan, you’ll need a credit score of at least 620. Government-backed loans have different requirements.
- You can afford the new monthly payment. Your lender will look at your debt-to-income ratio to make sure you can afford the new loan payment. You’ll likely need a DTI ratio lower than 43% to refinance.
- You can provide the necessary documentation. To help the lender verify your financial details, be ready to provide your W-2 or 1099 forms, income tax returns, recent pay stubs, current bank statements, and proof of homeowners insurance. Depending on your situation, other documents may be required.
Mortgage Refinancing Costs
You typically must pay closing costs when you refinance. According to Freddie Mac, the average closing costs for a refinance are about $5,000. You can refinance with your current lender or choose a new one, so it’s wise to shop around and compare.
Here are some common closing costs you may encounter when refinancing:
- Application fee. Lenders may charge a fee to review your application for a mortgage refinance.
- Appraisal fee. A home appraisal confirms the fair market value of your home and is important for determining the refinance amount.
- Loan origination fee. This covers the cost of setting up your home loan, verifying that you can afford it, and performing other administrative services.
- Title fees. A title search and title insurance protect both the borrower and the lender against any third-party claims on the property.
- Other closing costs. Additional costs may include attorney fees, credit report fees, government recording costs, and tax service fees.
How To Refinance a Mortgage in 7 Steps
Refinancing is a lot like getting a mortgage for the first time. Here are seven steps you can expect to take.
1. Prepare your finances
Start by checking your credit score. If it has increased, you may get a better interest rate when refinancing. If your score has decreased, then you may find it difficult to get favorable terms.
Lenders also will look at your DTI ratio, which shows how much of your income is taken up by debt payments. You typically need a DTI ratio of 43% or lower to get a mortgage or refinance.
You also will need to pay for closing costs on a refinance, which averages about $5,000.
2. Gather financial documents
To refinance your mortgage, you’ll have to gather your documents and provide them to your lender. Expect the lender to ask you for:
- Bank account statements.
- Loan statements.
- Pay stubs.
- Proof of homeowners insurance.
- Retirement and investment account statements.
- Income tax returns.
- W-2 or 1099 forms.
- Business profit and loss statements, if you’re self-employed or own a business.
Depending on your specific situation, additional documents may be necessary.
3. 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 owe on your current loan from the home’s fair market value. You can research the sales of comparable homes to get a reasonable idea of what your home is worth, and your current home loan balance can be found on your most recent mortgage statement.
4. Decide on the type of refinance
Next, you need to figure out which type of mortgage refinance is best for you, and whether you want to change your loan type:
- Rate-and-term refinance, which adjusts your interest rate or loan term.
- Cash-out refinance, which lets you borrow money against your equity.
- Cash-in refinance, where you pay money into your mortgage to reduce your principal.
- Streamline refinance, which offers a simplified refinance process for certain government-backed loans.
5. 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 lenders, be sure to note factors beyond price, including the 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.
6. Prepare for the appraisal
Most lenders require a new home appraisal to refinance your mortgage. It helps the lender verify that your new loan matches the home’s current value. You might not need a new appraisal with a streamline refinance.
7. 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 may take longer if your financial situation is complicated, but getting your paperwork ready in advance usually makes it easier.
How Long Does It Take To Refinance Your Mortgage?
Refinancing takes about 30 to 45 days. 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.
How Long Does It Take for Refinancing Your Mortgage To Pay Off?
Determining your break-even point will tell you how long you need to stay with your loan for it to save you any money. For example, let’s say you refinanced to a loan with a lower interest rate that is saving you $300 per month, but the closing costs on your new $200,000 loan were $7,200. It will take 24 months before you break even.
How Often Can You Refinance Your Mortgage?
There is no law limiting how often you can refinance, but your lender may make you wait a while before allowing you to do so. This is known as a “seasoning period,” and can last anywhere from six to 24 months, depending on the lender and type of refinance.
This only applies if you’re refinancing with the same lender. You can refinance with a different lender any time. Note that some lenders charge a prepayment penalty, so you should factor that cost into your refinancing decision.
If you’re looking to do a cash-out refinance, you’ll have to wait at least six months since your last refinance. You’ll also need to make sure you have enough equity to withdraw cash. Most lenders will only allow you to take out 80% to 90% of your equity. So, if you’ve already done a cash-out refinance and you haven’t had enough time to build more equity, another cash-out refinance may not be worth it.
Tips for Refinancing Your Mortgage
Here are some pointers for navigating the mortgage refinance process:
- Figure out how long you plan to own your home. It may not make sense to refinance if the homeowner plans to move soon. You could end up paying more to refinance than you’d save before you sell.
- Consider your loan term and what you can afford. The most common loan terms are 30 years and 15 years, though some lenders allow custom terms. Think about whether it’s worth making higher monthly payments in exchange for a shorter term and paying less interest overall. Alternatively, a longer term would reduce your payment but cost you more in interest.
- Research your lender carefully. You’ll be repaying your mortgage for years, so it’s a good idea to make sure you’re going to be working with a lender that you like.
- Get a rate lock. A rate lock can help you secure a low interest rate that won’t change between the time you apply for a refinance and the time you close.
- Consider using a mortgage broker. A mortgage broker will negotiate with lenders on your behalf to help you get the best possible terms on your refinance. If your financial situation is complicated or your credit isn’t so great, a broker could help you get a better interest rate.
Home Refinance FAQ
Here are answers to some common questions about refinancing your mortgage.
It doesn’t make sense to refinance if you don’t stand to benefit from it. If you’re not saving money or gaining access to money by borrowing equity, then it might not justify the costs of refinancing. If you aren’t planning on staying in the home long enough to break even, it might not be worth it to refinance.
You’ll typically need at least 20% equity in your home to refinance. Even if a lender allows you to refinance with less equity, you’ll likely be paying a higher interest rate in addition to PMI.
Having a mortgage lender check your credit is considered a hard inquiry, which can hurt your credit score temporarily. Consider submitting your loan applications all at once. Credit scoring models typically count multiple inquiries during the same 14-to-45-day period as just one hard inquiry, which minimizes the impact on your score.
Once the refinanced loan pays off your previous mortgage, you’ll be closing an older credit account, which can lower your credit score. Your score also will be affected because you haven’t proven your ability to pay off the new mortgage you’re taking on.
Even if your credit score declines after refinancing, don’t worry too much. After a while, it should bounce back — and even improve — as long as you continue making your mortgage payments on time.