How to refinance a mortgage

What is refinancing?

Refinancing is when you pay off your current mortgage by taking out another mortgage. 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 to capitalize on their home equity by refinancing for an amount that is greater than what they owe on the house, getting cash in return. Keep in mind that this type of refinance, known as a cash-out refinance, is different from a home equity loan or a home equity line of credit (HELOC).

A rate-and-term refinance loan replaces your current mortgage with a new loan that has a lower interest rate, a different term length or both. 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.

How does refinancing a mortgage work?

When you refinance a mortgage, 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 loan. In other words, refinancing replaces your current mortgage loan with a new mortgage loan.

In many ways, a refinancing loan works like a regular mortgage. Homeowners with a good or excellent credit score can often lower their interest rate by 1% or more. Refinancing is harder for those who have bad credit or a high debt-to-income ratio. You also have to pay closing costs and associated fees in order to finalize the new loan agreement. Keep an eye out for prepayment penalties, which can be expensive if you ever end up wanting to pay off your loan early or refinance again.

If you have a mortgage and are interested in refinancing, you can choose to refinance with your current lender or seek out a new one. If you switch, your refinancing lender will request a payoff statement from your servicer. Payoff statement forms include the principal balance and any fees that are owed on the loan.

Should I refinance my mortgage?

Consider how much interest you’ve paid on the old loan already versus how much refinancing will cost. A significant 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. 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 of your mortgage loan could lower your monthly payment, but you will also pay more interest over time.
• If you switch from an adjustable rate 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.

When should I refinance my home?

It’s usually best to refinance a mortgage when interest rates have fallen since you bought your house, you aren’t too far along with your mortgage payments and you plan to be in your house for at least several more years.

If you bought your house a few years ago, there’s a good chance that rates are lower now than they were then. So far in 2021, we’ve seen mortgage rates staying near historic lows. However, some housing data analysts expect rates to go up later this year.

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 associated with refinancing. You should compare the costs of refinancing against how much you expect to save with a new loan. If you expect to be in your home long enough to benefit from the savings refinancing can offer, you can start comparing refinancing lenders. For more, read about how soon you can refinance a mortgage next.

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.

Refinancing to lower your rate by 1% can be worth it.

1. 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 — or if you’re looking to take cash out from your home equity. Consider the various costs and fees that go along with refinancing. If you have an FHA loan, look into streamline refinancing.
2. Check your credit: Lenders evaluate your credit history to determine if you qualify for refinancing, and your credit score largely determines the rates at which you can borrow. If an error on your credit report is bringing your score down, take care of it before you start contacting lenders.
3. Calculate home value and equity: Find out your home’s current value and check how much you owe on the balance of your initial loan. Your home equity is the difference between the value of your home and how much you owe on your mortgage. Most lenders want this number divided by the home value to be at least 20%. It’s possible to refinance with less equity in your home, but it might not be worth it. Many lenders offer free refinance calculator tools online.
4. Compare multiple lenders: As you shop around, it’s smart to read reviews and compare rates from at least three companies. Lenders are required to give you a loan estimate within three days of receiving your mortgage application. Each estimate is three pages long and contains loan term details, projected payments, estimated closing costs and fees. Remember that it’s your responsibility to carefully compare details from each lender before you make a decision.
5. 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 financial documents — pay stubs, tax returns, W-2s or 1099s, statements of debts and statements of assets — and whatever other information your lender requires ahead of time. Be honest about your financial history and details on the application.
6. 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. You can usually lock a rate for 30 to 60 days — and sometimes longer. Your loan estimate may include a rate lock — check the top of the loan estimate to find out if so and how long it lasts.
7. Close the deal: Refinancing loans typically close more quickly than new purchase loans. Be sure you have enough funds to cover 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 pay mortgage points, or discount points, in exchange for a lower interest rate.
8. 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.

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 new loan with a shorter term means you pay off the loan faster, but because the payments are higher — you are paying more in principal each month — you could have less cash available for retirement savings or emergency expenses and find yourself in a complicated financial situation.

Benefits of refinancing a mortgage

Most people refinance to save money. The top reasons it makes sense to refinance are to lower your interest rate, change your loan term or both. You may also refinance to switch from an adjustable-rate mortgage to a fixed-rate mortgage or to get cash out of your home’s equity.

• Lower interest rate: A lower interest rate translates to a lower monthly payment and more of your payment going toward principal. The monthly payment difference may seem small, but they add up over time. You might be able to get a lower interest rate because of market conditions or because your financial situation has improved.
• Get rid of PMI: If your home’s value has risen and you refinance so that your loan balance is less than 80% of the home value, you won’t have to make PMI payments on a conventional loan.
• Faster repayment of mortgage: If you refinance with a shorter term, you will pay off a mortgage in less time — and probably get a lower interest rate. 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 sooner.

Risks of refinancing a mortgage

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.

• Closing costs: 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, title services and other fees add up quickly.
• Amortization resets: When you refinance a mortgage, you essentially have to start over and begin building equity all over again. Most of your early payments will be going toward interest, not principal. This is the reason that refinancing when you’ve had your mortgage for a long time usually isn’t a good idea.
• Financial risk: If you refinance your mortgage so that your monthly payment is higher, it could leave you with less financial flexibility in case of an emergency. There’s also a chance that you don’t recover your refinancing costs if you move out of the home earlier than you expected. And with a cash-out refinance, you own less of your home than you did before.

Bottom line: Is refinancing worth it?

Refinancing can potentially save you money and make repaying your home loan easier — but it requires careful thought and research beforehand. You might think about refinancing if interest rates are lower, your credit score has improved, you want to pay off your loan faster or you want to switch to a fixed-rate loan. It’s also possible to refinance with a longer term, but it will take longer to pay off your home and you will pay more interest overall. If you are near the end of your mortgage term, plan on moving soon or your current mortgage has a prepayment penalty, refinancing is likely not a good decision.