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What Is Mortgage Refinancing?

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Woman reviews financial refinance documents

When the housing market or your personal circumstances change — like if interest rates fall or you receive a big raise at work — refinancing your mortgage can help you get loan terms that are more favorable for your new situation.

When you refinance, you pay off your original loan with money from a new mortgage. Refinancing your home can help you save money on the total cost of your loan, pay off your mortgage sooner, or use the equity you’ve built to consolidate debt or take out cash.

Refinancing provides different options for homeowners, but it also comes with certain trade-offs. Here’s what it means to refinance a house, and how refinancing can help you achieve your financial goals:

What Is Refinancing a Mortgage?

So, what does refinancing a home mean? The definition of mortgage refinancing is to pay off your existing home loan with a new one that likely has more favorable terms.

In many cases, this means getting a lower interest rate that can help reduce your monthly mortgage payments — though you may end up owing more interest. You can also refinance to shorten your mortgage loan term and pay less in total interest in exchange for higher monthly payments. Other reasons to refinance include withdrawing cash using your home’s equity, or adding a co-borrower to your mortgage.

“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, vice president of Brooklyn MLS, a platform for real estate agents in New York City.

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How Does Refinancing a Mortgage Work?

When you refinance, you’ll follow many of the same steps from when you took out your original mortgage. Refinancing usually requires you to apply, get your credit checked, undergo a home appraisal, and receive approval to close on your new loan. The appraisal determines the current market value of your home, and an underwriter must verify that you can afford the mortgage. The refinancing process takes approximately 30 to 45 days, though the exact timeline can vary based on your financial situation.

Here are some of the requirements that you’ll likely need to fulfill to be eligible for a mortgage refinance:

  • You have enough equity in your home. You can think of equity as the value of your home minus the amount you still owe. To refinance, lenders often require that you’ve built at least 20% equity. If you don’t have 20% equity, your lender may still allow you to refinance, but you could get slapped with a higher interest rate or be required to buy mortgage insurance.
  • You’ve owned your home for at least six months. Before you can refinance, lenders often stipulate that you must own the home for a certain amount of time, especially if you’re looking to take cash out. The exact requirements will vary based on loan type.
  • 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 that can vary by lender, so it’s important to do your research before pursuing a refinance.
  • You can afford the new monthly payments. Your lender will examine your debt-to-income ratio to check if you have additional debts that could make it more difficult for you to pay your new mortgage. DTI ratios are calculated by dividing total monthly debt by gross monthly income. You’ll likely need a DTI ratio of 43% or lower.
  • You can provide the necessary documentation. To help the lender verify your financial details, you should expect to gather W-2 forms or 1099 forms, tax returns, pay stubs, bank statements, and proof of homeowners insurance and title insurance. Depending on your situation, other documents may be required as well.

Related: Guide to Refinancing

Costs of refinancing a home loan

Just like when you took out your original mortgage, you typically must pay closing costs when you refinance. 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 can include attorney fees, credit report fees, government recording costs, tax service fees, and more.

According to Freddie Mac, average closing costs for a refinance are roughly $5,000. You have the option to refinance with your current lender or a new one, so it can be wise to shop around and compare mortgage refinance lenders.

Mortgage refinancing example

Suppose that you originally took out a 30-year, fixed-rate home loan for $400,000 at an interest rate of 4%, and now you’re seven years into your mortgage. Interest rates have dropped, so you can refinance at an interest rate of 2.5%. However, you don’t want to start a new 30-year loan term, so you choose a custom 23-year term to pay off your mortgage as originally scheduled.

After refinancing to the lower interest rate, your monthly payment would shrink from $1,910 to $1,641 ⁠— a difference of $269 per month. Assuming that you’ll stay in the same home for the rest of the loan term, you would end up saving a whopping $178,728 in total interest by refinancing.

How refinancing affects credit

Refinancing can ding your credit score in a few different ways:

  • Getting hard inquiries on your credit report. Having a mortgage lender check your credit is considered a hard inquiry, which can hurt your credit score temporarily. If you’re comparing offers from lenders and shopping around over the course of several months, you could end up with multiple hard inquiries on your report.
  • Closing an established credit account. 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 will also be affected because you haven’t proven your ability to pay off the new mortgage you’re taking on.

If you want to avoid multiple hard inquiries, consider submitting your loan applications all at once. Credit scoring models typically count different inquiries during the same 14- to 45-day period as just one hard inquiry, which minimizes the impact on your score.

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.

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Different Types of Mortgage Refinancing

There are several ways you can refinance, depending on your goals. Here are different types of mortgage refinancing.

Rate-and-term refinance

A rate-and-term refinance allows you to adjust your mortgage interest rate and loan term, and is sometimes known as a regular refinance. These are some of the reasons to get a rate-and-term refinance:

  • Secure a lower interest rate on your mortgage to save on total interest paid.
  • Switch from an adjustable-rate mortgage to a fixed-rate mortgage with a steady interest rate and predictable monthly payments.
  • Own your home sooner and pay less interest by shortening your loan term and increasing your monthly payments.
  • Reduce your monthly payments by refinancing to a longer term and paying more total interest.

Related: Is a 15-Year or 30-Year Mortgage Better?

If the amount that you owe relative to the value of your home, aka your loan-to-value ratio, is too high to qualify for a standard rate-and-term refinance, Freddie Mac offers an alternative option: the Enhanced Relief Refinance. You can use this loan look-up tool to find out if Freddie Mac owns your mortgage, which is one of the requirements to get an Enhanced Relief Refinance.

Similarly, if you have a loan backed by the Department of Veterans Affairs and meet certain eligibility requirements, you may be able to get an interest rate reduction refinance loan. Check out the VA’s website for instructions on how to get an IRRRL.

Cash-out refinance

With refinancing, you can tap into the equity you’ve built in your home and withdraw cash. This is what’s known as a cash-out refinance.

For example, let’s say that your home is worth $500,000, and you still owe $300,000 on your mortgage. That means you have $200,000 in equity. You could refinance and take out a new home loan for $320,000, which would give you $20,000 in cash after you close.

Technically, you may do whatever you want with the cash. You can invest this money back into your home by making repairs or improvements to increase its value. Keep in mind, however, that you still need to repay that money.

Additionally, you must pay private mortgage insurance if you don’t have at least 20% equity left in your home after cashing out. The terms of your mortgage may also change, meaning that it could take you longer to pay off the loan or your monthly payments could increase. Be sure to verify the new details of your mortgage before closing.

Cash-in refinance

A cash-out refinance adds to the total loan amount and makes your money available in the short term, whereas a cash-in refinance does the opposite. With a cash-in refinance, you make a lump-sum payment to replace your current home loan with a smaller one. It’s a way to considerably reduce your principal, free yourself from paying PMI, or lower your monthly payments. Additionally, you may be able to score a better interest rate on the refinance because you’re improving your loan-to-value ratio.

However, a cash-in refinance can also come with trade-offs. By taking available money out of your pockets, you may end up sidelining other important financial goals, or run the risk of not having enough to cover emergencies.

Debt consolidation

If you have other high-interest debts, like growing balances across different credit cards, refinancing can help you consolidate those debts into one monthly payment at a lower interest rate. This is a specific way to use the equity you’re taking out with a cash-out refinance.

“This money can then be used to help pay off other debts you may have, which contain higher interest rates,” Orlando says.

While consolidating your debts can make them simpler to pay off, keep in mind that doing so may negatively affect your credit score. That’s because you’re taking on new debt and reducing the total number of credit accounts you have, which will lower the average age of your accounts.

Streamline refinance

A streamline refinance gets its name from the relatively light amount of credit documentation needed to complete the process. Interested borrowers should consult with individual lenders for specific terms.

If you have a loan backed by the Federal Housing Administration, a streamline refinance can help lower your monthly payments and interest rate. However, there are some limitations attached — for example, you can only take up to $500 in cash out.

The U.S. Department of Agriculture also offers a streamlined assist 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 this streamline refinance.

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Home Refinance FAQ

Here are the answers to some commonly asked questions on how to refinance your mortgage.

Will refinancing increase my mortgage?

Refinancing won’t automatically increase or decrease the size of your mortgage. The outcome depends on your new loan terms.

For example, if you refinance to lower your interest rate and monthly payments, you can save money in the short term but end up paying more money overall thanks to a longer loan term. However, if you refinance to repay your mortgage sooner with bigger monthly payments, then you’ll pay less in total interest.

Cash-out and cash-in refinances will affect your mortgage principal, but adjustments to your interest rate or the length of your term won’t.

Is it worth refinancing my home?

Whether it’s worth refinancing will depend on market conditions and your financial situation. “One should consider refinancing a home when they can substantially reduce the interest rate they are paying,” Orlando says.

According to Orlando, cutting your interest rate by 2 percentage points would be considered substantial. Additionally, he says it can be worth refinancing if you’ve received a promotion or raise, and your income has significantly increased to the point where you can afford higher monthly payments to pay off your home sooner.

“These types of substantial changes can help reduce a homeowner’s debt, and rapidly increase the equity in the property,” Orlando says.

However, if interest rates have increased or remained steady, it might not be worth refinancing.

“If a person chooses to refinance when there is no adjustment in the interest rate, they are taking on additional debt, which can cause them to have larger monthly payments than they currently have,” Orlando says. “Depending on a person’s income, this could severely affect a person’s monthly payment amount, and their overall ability to make those payments.”

What are the dangers of refinancing?

Refinancing comes with certain costs and trade-offs:

– If you refinance and then move again in the next few years, you likely won’t have enough time to break even on the closing costs.

– You could get slapped with a prepayment penalty if your lender charges a fee for paying off your mortgage earlier than expected.

– You could wind up paying more in total interest if you refinance to reduce your monthly payment and take longer to repay your mortgage.

– Shortening your loan term means your monthly payments will increase, and you might not be able to keep up with them anymore if your income changes or an emergency happens.

– Refinancing can cause your credit score to dip temporarily. Orlando says you should also make sure to review your credit report before refinancing. If there are any inaccuracies, it could prevent you from getting a lower interest rate.

What happens to escrow money when I refinance?

Your escrow account contains the money you spend on property taxes and homeowners insurance, and is facilitated by a third party. When you refinance your mortgage with the same lender, then the money you have in escrow will remain in that account. However, if you’re refinancing with a different lender, then a new escrow account will be created. You’ll receive a check with your escrow refund when your original account is closed.

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The Bottom Line on Refinancing a Mortgage

A refinance is when you pay off your original mortgage with a new one, which gives you the opportunity to change the terms of your loan. You can take advantage of low interest rates, a pay raise, or your home’s equity to achieve your financial goals. While refinancing is a choice, it’s worth evaluating whether you could benefit from a shift in market conditions or your personal situation.

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