It’s possible to lower your monthly mortgage payments or access home equity through refinancing. There are several potential benefits to refinancing a mortgage, especially if mortgage rates have dropped since you bought your house. However, before considering refinancing as an option, it’s crucial to understand how the home refinancing process works and the potential risks involved.
What is refinancing?
Refinancing is when you pay off one debt with another loan. When you refinance a mortgage, you borrow money to pay your mortgage in full and then repay the refinanced loan over time. In other words, refinancing replaces your current mortgage loan with a new mortgage loan.
A rate-and-term refinance loan replaces your current mortgage with a new loan that has a lower interest rate over approximately the same repayment period. Cash-out refinancing is more common when a home’s value has increased since the original mortgage was signed — it lets the homeowner tap into the equity they have built up over years of mortgage payments.
Refinancing lenders usually offer better interest rates and terms that make refinancing a viable financial option for many people, especially when interest rates are going down. It’s possible to refinance with a lower interest rate and a longer term, but adding years to a refinance mortgage loan means that it will take longer to pay off your home and you will pay more interest overall. If you’re refinancing your mortgage, you want to make your monthly payments more affordable while reducing your overall borrowing costs.
How does refinancing a mortgage work?
When you refinance a mortgage loan, you borrow money from a refinancing lender to pay off your original mortgage. Then, you pay back the refinancing loan, usually under more favorable terms than your first mortgage loan.
Homeowners seek different types of home refinance loans based on their financial goals. Most people refinance their mortgages to lower their interest rates, but sometimes refinancing is a way to eliminate the need for private mortgage insurance (PMI). Others seek a refinance to tap into home equity for a loan or line of credit.
In many ways, a refinancing loan works like a regular mortgage loan. Homeowners with good or excellent credit can often lower their interest rate by 1% or more, but refinancing is risky for those who have bad credit or a high debt-to-income ratio.
Since refinancing your mortgage essentially pays off the loan with a new one, your refinancing lender must request a payoff statement from your original mortgage lender. Payoff statement forms usually include the principal balance of the existing loan, the amount of interest due, daily interest charges, payoff statement fees and information relating to any escrow shortages or overages.
Should I refinance my mortgage?
The most crucial factor in determining if you should refinance your mortgage is whether you’ll save money overall — sometimes, the lower interest rate isn’t enough to offset the costs associated with closing on a mortgage refinance loan. Consider how much interest you’ve paid on the old loan already versus how much refinancing will cost.
Most people refinance their mortgage to lower monthly payments and save money. The top reasons it makes sense to refinance are to lower your interest rate, reduce your loan term or both. You may also refinance to pay a fixed interest rate instead of an adjustable interest rate.
When deciding whether to refinance a mortgage, consider:
- If you get a lower interest rate: If interest rates have dropped since you bought your house, you could save money by refinancing to a mortgage loan with a lower rate. Lower interest rates could save you money each month.
- If you get a shorter loan term: Homeowners can sometimes refinance to shorten their terms without much change in their monthly payments. This makes it easier to pay the mortgage off faster and build equity.
- If you get a lower interest rate and a shorter term: If you can shorten your term and lower your interest rates, you will pay less for the loan over time and own your home faster.
- If you get a longer term: Refinancing to extend the term or your mortgage loan could lower your monthly payments, but you will also pay more interest over time.
- If you switch to a fixed interest rate: If your original mortgage has an adjustable interest rate, switching to a fixed rate while interest rates are low makes payments more predictable. A fixed-rate mortgage loan also makes sense if you ever want to take out a home equity line of credit.
Don’t forget to consider payoff amounts and penalties when deciding if you should refinance your mortgage. One way to determine the payoff amount is to add your current balance to your mortgage payment.
Some lenders charge a penalty fee of more than 20% if the mortgage loan is paid within one year. On average, prepayment penalties are about 80% of six months worth of interest — be sure to request a payoff statement before you decide to refinance.
It usually only makes sense to refinance a mortgage if interest rates have substantially fallen since you bought your house and you plan to be in your house for at least several more years, but there are risks involved even then. It’s essential to pick the right loan terms — otherwise, your monthly payments could be too high to justify closing costs, which are typically 2% to 5% of your principal balance.
When should I refinance my home?
Generally, it’s better to refinance your mortgage earlier on in the term. For example, if you’re 10 years into a 30-year adjustable-rate mortgage, refinancing for a 20-year term with a lower fixed interest rate could be a smart financial move. However, if you only have a few years left on your original mortgage, refinancing might not be worth it even if you can lower your interest rate.
Be careful to consider how long it will take to break even on all fees and costs. You should compare the costs of refinancing against how much you’ve paid in interest so far plus what you owe on your current loan to get an idea of when to refinance. If you expect to be in your home long enough to benefit from the savings refinancing can offer, you should start comparing refinancing lenders.
How to refinance your home, step by step
In many ways, the steps to refinancing a mortgage loan are similar to the steps for taking out the original mortgage. Refinancing is available for all types of mortgage loans. In fact, if you have an FHA, VA, jumbo or USDA mortgage loan, look into options for a streamlined refinance process.
- Research refinance options: Before you start comparing refinancing companies, be sure that refinancing is the right option for your financial goals. Decide if you want a lower interest rate, a shorter term or both. Consider closing costs as well as the various refinancing fees.
- Check your credit: Lenders evaluate your credit history to determine if you qualify for refinancing, and your credit score largely determines the refinancing rates and terms available to you. If an error on your credit report is bringing your score down, take care of it before you start comparing refinancing lenders. Other factors, like your debt-to-income ratio, also affect the rates lenders can offer you.
- Know your house’s current value: Find out your home’s current value and check how much you owe on the balance of your initial mortgage loan — the amount of your home that you’ve already paid for is the amount of equity you currently have. It’s possible to refinance with a little at 5% equity in your home, but might not be worth it unless you have about 20% or more.
- Compare estimates from multiple lenders: It’s important to shop around for the best rates when refinancing. Refinancing companies are required to give you an estimate within three days of receiving your information. Each estimate is about three pages long and contains loan term details, projected payments, estimated closing costs and fees. Before you complete an application, be sure you have enough cash on hand to cover all expenses.
- Complete application: After you compare lenders to find the best rate available to you, you still need to be approved for refinancing, which is never guaranteed. Gather all your important documents — pay stubs, tax returns, W-2s or 1099s, credit reports, statements of debts and statements of assets — and whatever other information your lender requires ahead of time. It’s crucial to be honest about your financial history on the application. Otherwise, you could end up with rates and terms that aren’t realistic for your current situation.
- Lock in your rate: Once you decide on a lender, lock in your mortgage refinance rate so that it doesn’t unexpectedly change before closing day. Most lenders require a home appraisal to lock in a rate, which can be pricey — typically between $300 to $500.
- Close the deal: Refinancing mortgage loans typically close more quickly than new purchase mortgage loans. Be sure you have enough funds to cover property taxes, insurance and other expenses associated with the closing costs listed in your refinancing estimate. Closing costs are typically around 2% to 5% of the total loan amount and can sometimes be rolled into the mortgage balance, which decreases upfront costs but increases the total amount you owe. You could also have the option to buy mortgage points or discount points in exchange for a lower interest rate.
- Make payments: After the refinanced mortgage closes, your original mortgage is paid in full by the refinancing lender and you begin to make payments on your new mortgage loan to the refinancing company.
Pros and cons of refinancing a mortgage
Refinancing your mortgage loan can put you in a better financial position, but there are risks to consider as well. For example, a shorter term lets you pay off your loan faster, but you could have less cash available for retirement savings or emergency expenses and find yourself in a complicated financial situation. Remember that it’s your responsibility to carefully compare details from each lender before you make a decision.
- Better interest rate
- No PMI
- Pay off your mortgage sooner
- Closing costs
- Resets amortization
- Financial risk
Benefits of refinancing a mortgage
- Better interest rate: Lower interest rates let you pay less interest each month and over the life of the loan. Switching from an adjustable-rate mortgage to a fixed-rate mortgage makes your monthly payments more predictable. Many homeowners enjoy the comfort of knowing that their monthly mortgage payment will always stay the same.
- No PMI: You can typically stop paying private mortgage insurance (PMI) premiums if your refinance loan is for less than 80% of your house’s current appraised value.
- Pay off your mortgage sooner: Refinancing helps homeowners pay off their mortgage debt in less time. For example, if you refinance your 30-year mortgage to a 15-year mortgage, your monthly payments will increase, but you’ll own your home free and clear that much sooner.
Risks of refinancing a mortgage
- Can be costly: Refinancing your home is typically about as expensive as getting your original mortgage. Closing costs to refinance a mortgage average 2% to 5% of the total loan amount — usually several thousand dollars. Origination fees, appraisals, closing costs and other fees add up quickly. Some lenders even charge prepayment penalty fees for paying off mortgage loans early.
- Resets amortization: When you refinance a mortgage, you essentially have to start over and begin building equity all over again. This could add considerable time to how long it will take to pay off your house if you’ve only had the initial mortgage for a short time.
- Financial risk: If you default on a refinance home loan, your lender can seize your house and as well as your other assets.
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