The Basics of Mortgage Refinancing
Think of refinancing as restructuring your mortgage. You repay your original mortgage with funds from a new loan that usually has better terms.
The purpose is to help you achieve a financial goal, such as:
- Reducing your mortgage rate and saving on interest.
- Lowering your monthly mortgage payment.
- Changing your loan term.
- Borrowing cash against your home equity to cover major expenses.
- Consolidating debts.
How does refinancing work?
Let’s say you bought your home by borrowing $400,000 at a 4% interest rate, and you are repaying it over 30 years. Several years after taking out that mortgage, you’ve paid down your principal balance to $375,000, interest rates have dropped, and your credit score has increased. If you refinance your mortgage at a 3.5% interest rate with a new 30-year term, your monthly payment will be lower. The trade-off is that your loan term starts over, and you’ll be making payments longer and paying more in overall interest.
That’s just one of many approaches you can take with refinancing. If you’re looking to pay off your mortgage more quickly, you could refinance from a 30-year loan to a 15-year loan. You’ll pay less overall in interest, but your monthly mortgage payment will go up.
You also can borrow cash against your home’s equity — which is the difference between what your home is worth and how much you owe on it — by refinancing for more than you owe on your current mortgage. Equity grows over time if the value of your home appreciates, and as you pay down the mortgage principal.
You can use the cash from refinancing your home for any purpose, but you must repay it as part of your new mortgage. Many homeowners use cash-out refinancing to pay for home improvements or other major expenses such as college tuition, or to retire high-interest debts like credit cards.
How long does it take to refinance a 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 often can your 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 sometimes 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 anytime you like. 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 have 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 since then, another cash-out refinance may not be worth it.
When Should You Consider Refinancing a Home?
A mortgage refinance can have a major effect on your finances, so you should think through whether refinancing makes sense for you.
“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 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 recoup the cost of refinancing. It usually 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 how much money you could save with a refinance.
“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 reasons to refinance apply to your situation, then you may benefit from refinancing your mortgage:
- You want to reduce your monthly payment. If interest rates have dropped, then you may be able to lower your monthly mortgage payment by refinancing. Remember that paying off the remainder of your balance over a longer period can help you reduce your monthly payment, but likely will cost you more in overall interest.
- 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 rate and save money.
- 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. The rate you pay on an ARM will change throughout the loan term, which means an increase in market interest rates could raise your monthly payment. Refinancing to a fixed-rate mortgage protects you from such increases and makes your monthly payment predictable.
- You need cash. If you do a cash-out refinance, you can borrow against your home’s equity and use that money to consolidate debts or pay for major expenses such as home improvements, medical bills, or college tuition.
- You’re trying to eliminate private mortgage insurance. If you bought your home with a conventional loan and a down payment of less than 20% of the purchase price, your lender likely requires you to buy private mortgage insurance. If your home has increased in value enough to give you more than 20% equity in your home, refinancing would let you stop paying for PMI.
- You want to consolidate mortgages. If you have a second mortgage or home equity line of credit, you could refinance to fold those debts into your primary mortgage and eliminate the need to pay multiple bills.
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 payment and the total cost of your loan. If your credit score has declined since you bought your home, then it will be difficult to refinance with better loan terms.
- Your home’s value has decreased. In ideal circumstances, your property appreciates in value over time — especially if you maintain it well and make home improvements. But if the fair market value of your home declines, then refinancing with better terms may be difficult.
- You plan to move soon. If you expect to relocate in the near future, 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. Equity takes time to grow. “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 with your lender to find out if your current mortgage includes a prepayment penalty that you have to pay if you refinance.
- You would be extending your loan term. Refinancing to lower your interest rate and monthly mortgage payment may result in a longer loan term, which means you would be making payments longer.
Home Refinancing Costs To Consider
Refinancing comes with closing costs, just like your current mortgage. Closing costs on a refinance average about $5,000.
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. It is typically required by lenders and usually costs around $300 to $500.
- Discount points. Mortgage points are upfront charges that reduce your interest rate. The cost will depend on how much your lender charges, as well as how many points you buy.
- Loan origination fee. Your lender charges a fee to set up your loan and to cover the cost of underwriting, which is the process of verifying your ability to repay the mortgage. This typically costs 0.5% to 1% of the loan amount.
- PMI. If you’re taking out a conventional loan and your down payment or equity in the home when you refinance is less than 20%, then you’ll 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 you borrow.
- Title search fee. This covers the cost of ensuring the title to the home is free of conflicting claims or liens, such as unpaid taxes. A title search generally costs between $75 and $200.
How To Refinance a House in 6 Steps
Refinancing is a lot like getting a mortgage for the first time. Here are six 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 a refinance. Get ready to evaluate your finances and prepare your documents for lenders.
Check your credit score and debt-to-income ratio
Before you refinance, you’ll want to know 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 look at your debt-to-income ratio, which is calculated by dividing your total monthly debt payments by your gross monthly income. 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. You typically need a DTI ratio of 43% or lower to get a mortgage or refinance.
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 owe on your current 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 on a home loan is usually lower than you could get with other forms of credit.
3. 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:
- Conventional loan refinance. Conventional loans can be less expensive than other loan types, especially if you don’t need to pay for PMI. For borrowers with a different loan type, it may be worth refinancing to a conventional loan if you have enough equity. If you already have a conventional loan, you have three primary options to refinance:
- 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.
- Rate-and-term refinance, which adjusts your interest rate or loan term.
- FHA loan refinance. Loans backed by the Federal Housing Administration offer a streamlined refinance process with limited underwriting and documentation. While this can be a good way to lower your interest rate and monthly payment, the process still comes with costs, and you can’t take out more than $500 in cash.
- VA loan refinance. VA loans are offered to eligible 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.
- USDA loan refinance. USDA loans are offered to low- and moderate-income borrowers in rural areas. The USDA streamline refinance helps you refinance to lower your interest rate and monthly payment without a new appraisal, home inspection, or credit review.
4. 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.
5. Prepare for the appraisal
You’ll likely need 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 if you have an FHA loan, VA loan, or USDA loan, as those loans offer streamlined refinances.
6. 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 should make it easier.
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 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 custom terms. Think about whether it’s worth making higher monthly payments with a shorter term in exchange for paying less interest overall. Alternately, 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. “Always work with a reputable lender who can advise the best path to follow and guide you through the process,” Boomer says.
- 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.
Mortgage Refinancing FAQ
Still have questions about refinancing? Let’s answer some frequently asked questions.
Not necessarily. While you can begin another 30-year or 15-year term, many lenders let you refinance with a custom term of as many years as you like. This can be useful to ensure your home is paid off on a schedule of your choosing, and could help you save money on interest.
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.
Some lenders offer a no-closing-cost refinance, which allows you to 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.
It’s possible to refinance if your credit score has decreased since you first took out your loan — but it might not be worthwhile, since it will be more difficult for you to score a better deal. After all, your credit score has a big effect on the interest rate that you’re offered.
If you need to lengthen your loan term or take out cash for an emergency, then refinancing is possible so long as you can still meet the minimum requirements set by your lender. Just make sure you understand the trade-offs first.