How Does Refinancing a Mortgage Work? A Homeowner Planning Guide

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As a homeowner facing life changes or new opportunities, you may be considering the benefits of refinancing your mortgage loan. Perhaps you’re in need of cash, or you’d like to lower your monthly payment. Or maybe you just want to shorten your loan term.

While many borrowers have placed plans on hold due to higher interest rates, there may be reasons a mortgage refinance is in your future.

“It’s always worth talking about refinancing,” says Clint Hammond, a mortgage expert in Columbia, South Carolina, with more than 20 years of experience. “Whether it’s going to make sense enough to conduct the transaction is another matter.”

In this post, we’ll look at how refinancing a mortgage works, what you can expect, and how to decide if leveraging this financial tool is right for you.

How Much Is Your Home Worth Now?

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What does it mean to refinance your house?

Refinancing your house means replacing your existing mortgage with a new loan, typically with different terms and interest rates. This financial move is often aimed at reducing monthly mortgage payments, changing the loan’s duration, or tapping into home equity for large expenses. In simpler terms, it’s like hitting a reset button on your mortgage, but with the goal of bettering your financial situation.

Homeowners opt for refinancing for various reasons, such as taking advantage of lower interest rates, switching from an adjustable-rate to a fixed-rate loan, or vice versa. It’s a strategic decision that can offer financial flexibility or savings, but it also requires careful consideration of the costs and benefits involved.

“Factors to consider: Is there a need? Buying a home is obvious: I have to have somewhere to live. Needs to refinance are different,” says Hammond. “A true need would be, ‘I can’t afford my payment, I have to get it lower.’ Another true need would be, ‘I need cash to address something,’ whether it’s a renovation project or a large obligation like a medical bill or tax situation.”

How does refinancing work?

Refinancing a mortgage involves several steps, many of which are similar to the steps in the process you went through to obtain the first mortgage on your home. Here’s a simplified breakdown of how refinancing a mortgage works:

1. Assess your financial goals: Before diving into refinancing, it’s important to know why you’re doing it. Are you looking to lower your monthly payments, shorten your loan term, or get cash from your home equity? Your goals will guide the refinancing process.

2. Check your credit score and history: Your credit score significantly impacts the interest rates you can secure. Ensure your credit history is in good shape and correct any errors on your credit report.

3. Understand your home’s equity: Know how much of your home you actually own. This equity plays a vital role in determining if you qualify for refinancing and the terms you’ll get.

4. Shop around for the best rates: Don’t settle for the first offer. Compare rates and terms from different lenders to find the best deal for your situation.

5. Get your documents in order: Prepare the necessary financial documents. These typically include recent pay stubs, tax returns, and bank statements, among others.

6. Apply for refinancing: Once you’ve found a suitable lender, fill out an application. Be prepared for a thorough review of your financial situation.

7. Go through the home appraisal process: Lenders will require an appraisal to determine the current value of your home. This impacts how much you can refinance.

8. Close on the new loan: If approved, you’ll go through a closing process similar to when you first obtained your original mortgage. This will involve signing a host of documents and possibly paying closing costs.

9. Start paying your new mortgage: After closing, you’ll start making payments on your new loan, now adjusted according to your refinanced terms.

While refinancing can be beneficial, Hammond says it’s important to consider the entire picture, including costs and potential savings, to ensure it aligns with your financial goals. In addition, there are different types of refinancing options available.

Different types of refinancing

Homeowners have various refinancing options, each serving different financial needs and situations. These options can be grouped into more common and less common types.

Most common types of refinancing:

  • Traditional rate-and-term refinance: This is the standard refinance option. Homeowners can change their interest rate, loan term, or both without changing the loan amount.
  • Cash-out refinance: Allows homeowners to refinance their mortgage for more than they owe and take the difference in cash. It’s useful for large expenses like home renovations or emergency situations when cash is needed.
  • Cash-in refinance: Homeowners bring cash to closing to lower their mortgage balance or loan-to-value (LTV) ratio, often to get a lower interest rate or remove private mortgage insurance (PMI). This option can be strategic if you receive a large cash bonus or inheritance.
  • Debt consolidation refinancing: This involves refinancing your mortgage and consolidating other debts into the new loan, ideally at a lower overall combined interest rate.

Less common types of refinancing:

  • No-closing-cost refinance: Some lenders offer to pay closing costs or fold them into the loan in exchange for a higher interest rate.
  • Short refinance: In a financial hardship that puts you at risk of foreclosure, a lender might agree to forgive some of your debt and refinance the rest into a new, more affordable loan.
  • Reverse mortgage: Available to homeowners 62 years or older, a reverse mortgage allows a homeowner to convert part of their home equity into cash while still owning their home.
  • Streamline refinance: Designed for loans like FHA, USDA, and VA loans, this option simplifies the refinancing process with minimal paperwork and lower closing costs. Such loans may let you skip the credit check or appraisal.

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Two example refinancing scenarios

Traditional rate-and-term refinance example: Imagine Sarah and John bought their home with a 30-year fixed-rate mortgage at a 6% interest rate. Their monthly mortgage payment was $1,200. When rates went down, they refinanced at a 4% interest rate. By refinancing to the lower rate while keeping the same loan term, their new monthly payment dropped to approximately $1,000, saving them $200 per month. Over the remaining 25 years of their mortgage, this adds up to significant savings.

Cash-our refinance example: Consider Emily, a homeowner with a remaining mortgage balance of $200,000. Her home’s current market value is $400,000, giving her substantial equity. Looking to renovate her home and consolidate high-interest debt, Emily opts for a cash-out refinance. She decides to cash out $82,000, a common dollar amount for U.S. homeowners. This increases her total mortgage balance to $282,000. With this refinancing, Emily’s monthly payment increases by approximately $150. However, she now has the funds for her home renovation and debt consolidation.

Top reasons homeowners refinance

Homeowners choose to refinance their mortgage for a variety of reasons, each offering its own set of benefits. Here are some of the top reasons:

1. Lower interest rates: One of the most common reasons for refinancing is to secure a lower interest rate, which can significantly reduce monthly mortgage payments and total interest costs over the life of the loan.

2. Shorten loan term: Refinancing can allow homeowners to switch from a 30-year to a 15-year mortgage, for example. This can lead to paying off the loan faster and saving on interest, despite a potential increase in monthly payments.

3. Convert between adjustable-rate and fixed-rate mortgage: Homeowners might refinance to switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage for more predictable payments, or vice versa for lower initial rates.

4. Cash-out equity: As seen in the cash-out refinance example, homeowners can tap into their home equity to cover large expenses, such as home renovations or debt consolidation.

5. Remove private mortgage insurance (PMI): If a home’s value has increased, refinancing can help homeowners reach 20% equity, allowing them to eliminate PMI and lower their monthly expenses.

6. Debt consolidation: By consolidating high-interest debts into a mortgage with a lower interest rate, homeowners can manage their finances more effectively.

Drawbacks of refinancing your mortgage

While refinancing can offer significant benefits, it’s important to be aware of its potential drawbacks. Here are some key considerations:

1. Closing costs: Refinancing a mortgage involves closing costs, which can range from 2% to 6% of the loan amount. These costs can add up, potentially offsetting the savings gained from lower interest rates.

2. Longer loan term: If you refinance into a new 30-year loan, for instance, you could end up paying more in interest over the life of the loan, even if your monthly payments are lower.

3. Risk of foreclosure: By refinancing, you’re essentially taking out a new mortgage. If you fail to make payments, you risk foreclosure, just as with your original mortgage.

4. Lost benefits: Some original mortgages might have special features like federal loan forgiveness that could be forfeited upon refinancing.

5. Impact on credit score: Refinancing can temporarily impact your credit score due to the lender’s credit inquiry and the closing of the old mortgage account.

6. Potential for higher payments: If you opt for a cash-out refinance, your overall loan balance increases, which could lead to higher monthly payments.

7. Borrower’s remorse: If interest rates drop substantially after you close on your refinance, you might have regrets about the timing and costs.

8. Interest rate risk: For those switching to an adjustable-rate mortgage, there’s the risk of interest rates increasing in the future, which could raise monthly payments.

How much does it cost to refinance a mortgage?

Refinancing a mortgage typically costs between 2% to 6% of the loan amount. These costs include application fees, appraisal fees, title searches, and closing costs. For example, refinancing a $200,000 loan might cost between $4,000 to $12,000.

But Hammond reiterates that it’s important to consider the overall price of refinancing. “Don’t get caught up in interest rates.”

If you’re planning to move within the next year or two, the costs of refinancing may actually cause you to lose money. Similarly, if your loan balance is relatively low, you may be better off sticking with your current mortgage.

“If I have a $100,000 loan balance and I can reduce my rate by 1%, that sounds like a lot, but in terms of real dollars, it won’t reduce the payment by much,” says Hammond, who warns that a portion of the costs associated with refinancing are flat-rate and independent of the loan size.

“If an appraisal costs $425 and a closing attorney costs $495, I’m paying those amounts regardless of whether I’m refinancing $100,000 or $500,000. The dollar for dollar [on these costs] is the exact same, but saving 1% interest on $500,000 is far more substantial.”

Hammond encourages homeowners to talk through the process with a trusted lender and put a plan together that finds the most efficient use of their time and money.

A 1% rate drop may not be worth it

“I hear people say all the time, ‘I’ve got to reduce my rate by 1% for it to be worth it,’ and, well, that’s bogus,” says Hammond. “I don’t talk about refinancing in terms of the interest rate, I talk about it in terms of the cost-benefit. You want to consider the change in the dollar amount coming in or going out each month, in relation to the cost of getting there.”

The same rationale applies if you’re looking to shorten your loan term, remove mortgage insurance, or take out cash from the equity in your property.

“The refinance transaction where you only drop your interest rate by a quarter of a point but you also eliminate your monthly mortgage insurance? That’s a transaction you do all day long,” says Hammond. “That’s going to be a huge dollar figure in terms of savings.”

If you’re looking to shorten your loan — say, refinancing from a 30-year mortgage to a 15-year mortgage — your monthly payment may increase while your interest rate goes down, allowing you to pay down the loan principal more rapidly, if you’ll be in the house long enough for the numbers to make sense.

FAQs about refinancing your mortgage

Is refinancing your mortgage right for you?

Deciding to refinance your mortgage is a significant financial decision. “It’s not a good idea or a bad idea,” says Hammond. “It’s an idea to be discussed. You hash it out and let the numbers tell you what makes the most sense.”

To determine if it’s the right choice for your situation, ask yourself these questions:

1. Will refinancing lower my rate or payments enough to justify the costs? Consider if the savings from refinancing outweigh the closing costs and fees involved.

2. How long do I plan to stay in my home? If you plan to move soon, you may not stay long enough to recoup the costs of refinancing.

3. What are my financial goals? Are you looking to reduce monthly payments, pay off your mortgage faster, or use your home equity for large expenses?

4. How will refinancing impact my overall financial plan? Think about how changing your mortgage terms fits into your broader financial strategy.

5. Am I prepared for the potential impact on my credit score? While usually temporary, refinancing can affect your credit, so consider the timing if you have other major credit applications planned.

Refinancing can offer significant financial benefits, but it’s not a one-size-fits-all solution. Each homeowner’s financial situation is unique. Consider consulting with a financial advisor to ensure that your choice to refinance aligns with your long-term financial plans. This professional guidance can help you make an informed decision that best suits your individual needs and goals.

Learn more: See our list of upgrades that can add value to your home.

Writer Summer Rylander contributed to this story.

Header Image Source: (Jessica Furtney/ Unsplash)