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Mortgage Refinancing: How Does It Work & When to Refinance
Key takeaways
- Refinancing replaces your current mortgage with a new one that may better match your goals and budget
- Your interest rate, equity, type of refinancing, and timeline can affect whether refinancing might lower your overall costs or increase them
- Compare refinance types, fees, and break-even timing before you apply, and review final disclosures carefully
Mortgage refinancing lets you replace your existing home loan with a new one, with the goal of gaining more favorable terms. It's a powerful financial tool that can be beneficial in a number of scenarios. Knowing whether it makes sense for your situation is crucial to making confident decisions about your financial future.
What is mortgage refinancing?
If you've never done a refinance before, you can think of it as swapping your old mortgage out for a new one. The new loan, which can be used to pay off the previous one, usually comes with different repayment terms and may offer a lower interest rate. After the refinance takes place, you begin to pay off the new mortgage.
Why do homeowners refinance?
Refinancing a mortgage isn’t a one-size-fits-all decision, but it can support several different financial goals:
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Lower interest rates. This is one of the most common reasons homeowners refinance home loans. The lower interest rate may reduce the total amount of interest paid over the life of the loan
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Reduce monthly payments. Many homeowners refinance to lower their monthly payments, freeing up cash for other purposes
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Shorten or extend loan terms. Shortening the payoff period of the loan could enable homeowners to get out of debt faster. Extending the payoff period may lower mortgage payments and provide short-term budgeting flexibility
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Switch from adjustable to fixed rates. Replacing an adjustable interest rate with a fixed rate makes monthly payments predictable and protects the borrower from future rate increases
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Tap into home equity (cash-out refinance). Homeowners can convert home equity into cash, which can then be used at the homeowner’s discretion for things like home renovations, education expenses, or debt consolidation
How does mortgage refinancing work?
Refinancing isn’t a shortcut—lenders still review your credit, assess your finances, and complete underwriting before closing the loan. Here's a basic look at how mortgage refinancing works.
1. Applying for a new mortgage
Remember what your first mortgage approval was like? You had to fill out an application, provide verification for your income, employment, debts, and assets, go through a credit check, and close on the loan. You’ll go through these same steps when you complete the refinance loan process.
2. Locking in your interest rate
Some lenders will let you lock in an interest rate while the application is being processed. If interest rates increase during the agreed-upon time, your rate doesn’t change. But if rates fall during the process, you won’t benefit from that. Lenders might charge for rate locks, and they might also charge for a float-down option that enables you to get a lower rate if rates fall during the approval process.
3. Appraisal of your home
Refinancing does not use the home's original appraisal. Instead, you’ll typically need a new appraisal to determine the current market value. If the value has increased, this may help you secure more favorable terms on the new loan.
4. Underwriting and approval
Underwriters use your application, supporting documentation, and credit report to verify your financial information to make sure you meet all the loan requirements. If needed, you may be asked to provide additional documentation.
5. Closing on the new loan
After the approval process is completed, you will receive a payoff statement stating that the new loan has paid off the old one. You’ll also receive a closing disclosure that details the loan terms and when your first payment is due on the new loan.
Types of mortgage refinancing
Refinancing a mortgage isn’t a one-size-fits-all decision, but it can support several different financial goals. There are several types to choose from, so it's important to compare each one to see which type has refinancing requirements and features that best fit your financial situation.
1. Rate-and-term refinance
Most homeowners choose a rate-and-term refinance when they want to make practical changes to their existing mortgage. It can help lower the interest rate, so you pay less over time while also letting you adjust the loan length to better match your financial goals. This option can also be used to move from an adjustable-rate mortgage (ARM) to a fixed-rate loan, making your monthly payments more predictable and easier to plan for.
2. Cash-out refinance
This type of mortgage refinancing taps into the equity you've built through the years as you've made payments. It's an excellent option when you need cash upfront for:
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Home improvements
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Debt consolidation
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Education costs
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Major expenses
3. Streamline refinance
Borrowers with qualifying government-backed mortgages, such as FHA, VA, or USDA loans, may be eligible for a streamlined refinance option. This can cut down on paperwork and processing requirements, making refinancing faster and less complex. This type of refinance involves:
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Reduced documentation. Less income, asset, and employment verification is required
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No appraisal requirements. Eliminates the need for an updated home value assessment
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Faster approval. Shorter processing timeline due to simplified underwriting steps
Benefits of mortgage refinancing
There are several mortgage refinance benefits that could motivate people to take this step, including:
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Lower interest rates. A lower rate helps to make your home more affordable because you don't pay as much in interest
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Lower monthly payments. Smaller mortgage payments can help you balance your budget and attend to other financial priorities
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Shorter loan payoff period. Being able to pay off your mortgage sooner rather than later provides greater peace of mind and financial freedom
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Switching to a fixed rate. A mortgage with a fixed rate delivers predictability that shields borrowers from market fluctuations
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Tapping into home equity. Refinancing allows you to turn built-up equity into cash when large expenses arise
When to refinance a mortgage
Refinancing is most effective when key financial factors work in your favor.
1. Interest rates are lower than your current mortgage rate
Under the right conditions, refinancing to a lower interest rate can reduce your total interest costs.
2. Your credit score has improved
You're more likely to qualify for favorable terms if your credit score has improved since you took out the original mortgage.
3. You want lower monthly payments
Refinancing allows you to change the structure and terms of the loan so you enjoy more affordable payments.
4. You want to pay off your mortgage faster
Doing a refinance to shorten the loan term can help you build equity faster and pay less interest overall.
5. You want to consolidate debt
Mortgage refinancing could enable you to roll several debts into a single, easier-to-manage payment, making it simple to consolidate debt.
6. Your home value has increased
Building equity can make it easier to qualify for a wider range of refinancing options.
7. You want to switch from an ARM to a fixed rate
Refinancing supports clearer financial planning over time when you lock in a fixed rate that protects you against future rate increases.
Costs to consider before refinancing
Before refinancing, homeowners should carefully review the expenses that come with the new loan.
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Appraisal fees. Lenders usually require a professional appraisal to determine the current market value
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Origination fees. Lenders may charge upfront fees for processing and approving the home mortgage refinance loan
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Refinance closing costs (typically 2%-5% of the loan amount). Refinancing includes multiple fees that can total several thousand dollars
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Prepayment penalties (if applicable). Some loans charge fees for paying off the existing mortgage early
It’s also important to consider how long you plan to stay in the home. It could take a certain amount of time before the costs of refinancing will be outweighed by any savings you gain. Ideally, you would want to stay in the home long enough to surpass the break-even point after refinancing.
FAQs
When you refinance your mortgage, you get a new loan to pay off your old one. The new mortgage pays off the existing balance and has new conditions, including a different interest rate and/or loan duration.
Homeowners often refinance to make their payments more affordable, to lower their long-term expenditures, or to get a loan that better fits their changing financial circumstances.
The steps for refinancing are like those for acquiring your first mortgage. You fill out an application, provide current financial information, and go through a credit check and underwriting process. The lender may or may not allow you to lock in the interest rate as of the application. Once the new loan is authorized, it closes and takes the place of your current mortgage.
Refinancing is not free. You typically have to pay lender fees, appraisal charges, and closing costs that range from 2% to 5% of the loan amount. Some lenders offer no-closing-cost refinance loans, which allow you to add the closing fees to the principal balance instead of paying them up front. While this can reduce out-of-pocket closing costs, it could make your monthly payments higher.
Comparing fees to potential long-term savings will help reveal whether refinancing is the right choice for your situation.
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