What Is Mortgage Refinancing And How Does It Work?

Have you ever wished you could speed up the process of paying off your mortgage? Would you prefer to make lower payments to your lender?

You may have heard about the possibility of home loan refinancing. But what exactly is refinancing, and does it make sense for your situation? Let’s find out.

What Is Refinancing?

Refinancing a mortgage means that a lender swaps out your mortgage for a new one. You can tap into several types of refinances. For example, borrowers who choose to refinance can opt for a lower interest rate or a lower monthly payment using a rate-and-term refinance.

Homeowners can also refinance with a cash-out refinance, which allows you to tap into your home equity – the difference between the value of your home and the amount you owe. You can typically take out up to 80% of your home value through a conventional cash-out refinance.

Other possible reasons to refinance your mortgage include consolidating high-interest debt, eliminating private mortgage insurance (PMI) and removing someone from the loan after they’ve moved out or as the result of a divorce.

How Does Refinancing Work?

When refinancing a mortgage, a lender will look at your credit score, income, assets and debt to determine whether you meet the requirements to qualify. Lenders also want to make sure that you’re likely to pay off your mortgage. Let’s take a closer look at the qualifications:

• Credit score: Lenders will review your credit score along with all your other qualifications. You don’t need to have a perfect credit score, but you must have at least a decent score to qualify for a mortgage refinance.

• Income: Your income shows your lender the amount of risk you present when repaying your loan. Your lender will want to confirm that you have sufficient income to make your monthly payments.

• Your equity: You must build up enough equity in your home before refinancing. Your lender will take your equity into consideration, plus the other qualifications you bring to the table.

Your lender then replaces your mortgage with a new mortgage, and you start repayment on your new loan amount. Your monthly mortgage payment might change. For example, you may make lower monthly payments if you extend your loan term. On the flipside, you might make higher monthly payments if you reduce your loan term. 

Common Types Of Home Refinancing

Now let’s walk through a few common types of refinancing: a cash-out refinance, rate-and-term refinance and streamline refinance.

Cash-Out Refinance

Cash-out refinancing means you take out a new home loan on your property for a larger amount than what you owe on your original mortgage. You receive the difference between the two loan amounts in cash. The larger loan replaces your original loan.

You can use the cash that you withdraw from your mortgage for anything from consolidating debt to funding home renovation projects.

Rate-And-Term Refinance

A rate-and-term refinance means you can opt for a different interest rate and loan term based on your existing mortgage. You may consider this option when interest rates are lower, and you can get more favorable terms with your lender.

The mortgage loan amount doesn’t change with a rate-and-term refinance, but you can end up with lower monthly payments or a shorter loan term. You can also extend your loan terms if you don’t feel comfortable with your current monthly mortgage payments. In this case, you’d make more payments over a longer term.

Streamline Refinance

Streamline refinancing means you can potentially refinance without having to undergo new appraisals or inspections on your property. You may also lower your monthly payments and interest rates.

You may be able to refinance FHA, VA, and USDA loans this way. Explore these opportunities with your lender directly. You must typically already have one of these types of loans in order to qualify for a streamline refinance.

How To Refinance Your Mortgage

Let’s take a closer look at the steps to refinance a mortgage.

Talk With A Lender

The refinancing process kicks off when you start exploring your refinance options with a mortgage lender. This individual can help you explore the types of refinancing options they offer and help you determine whether you qualify for refinancing.

Apply To Refinance

Once you decide to refinance, you’ll need to apply with the lender you’ve chosen. Lenders will consider a number of items, including:

• Income

• Debt

• Credit score

• Total assets

• Recent pay stubs, W-2s and bank statements

Lock In A New Interest Rate

Once your lender has prequalified you for a refinance, they’ll give you the loan terms, including your new interest rate. Once you agree to the terms, your loan rate should be locked, meaning that the interest rate quoted won’t change between when you accept the terms and when you close on the refinance.

Underwriting

Once you’ve submitted your documents, the loan will go through a process called underwriting. This means your information goes to an underwriter, who verifies all of the documents you’ve provided, including your financial information. The underwriter may ask additional questions to make sure they have everything needed to approve your new loan.

Appraisal

Your home will likely need to undergo an appraisal for refinancing. An appraisal determines the fair market value of your home and is important because it gives you an idea of your home’s appreciation and depreciation. It also helps you understand how much equity you can tap into.

The process starts when your lender orders the appraisal. Next, an independent, professional appraiser comes to your home and evaluates items like your home’s square footage and the number of rooms. The appraiser will also compare your home with other homes in the area before deciding whether the refinance makes sense based on the value of your home.

Close On The New Mortgage

Once all documents have been approved, you’ll close on your new mortgage. You’ll pay closing costs, which include items like the origination fee (the cost to process your loan) and appraisal fee. The closing costs and fees will be available to you ahead of time as part of your Closing Disclosure.

Start Making New Payments

Once your new loan is ready, it’s time to start making mortgage payments. Consider setting up auto payments so you never miss a due date.

Pros And Cons Of Refinancing

What are the downsides and advantages to refinancing a mortgage?

Pros

First, the pros:

• You may pay your loan off faster. Let’s say you decide to switch from a 30-year mortgage to a 15-year mortgage. Shortening your loan term means you’ll pay your loan off faster.

• You could save money. If you choose to shorten your mortgage term, you could save money on interest over the life of your loan. Once you pay off your loan, you’ll save from month to month because you’ll no longer have to make payments to your lender. Even if you don’t shorten the length of your mortgage, you may end up saving money through reduced interest rates.

• Your payments may become more predictable. If you go from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, your payments will become more predictable. The difference between a fixed and adjustable-rate is that an ARM’s interest rate may rise and fall with changing market rates but your interest rate stays the same with a fixed-rate mortgage over the life of the loan.

• You can use cash-out equity as you wish. If you choose a cash-out refinance, you can put the money toward adding a pool to your backyard, making home improvements, paying for college or another expense.

Cons

Now, the cons of refinancing a mortgage:

• Closing costs could put a damper on potential savings. The savings from a refinance might not actually equal that much money over time because of the closing costs you must pay. You might end up only breaking even.

• You might extend your loan payment. Maybe you choose to refinance from a 15-year mortgage to a 30-year mortgage. You’ll pay on your mortgage for an extra 15 years and incur more interest. Even if it seems more comfortable for you to do this, you’ll still end up paying more out of pocket over the long term.

• You could reduce the equity in your home. When you utilize a cash-out refinance, you borrow against the equity in your home and reduce your equity. In other words, if you have $60,000 equity in your home and take $30,000 out in a cash-out refinance, you’ll have $30,000 of equity left.

Should I Refinance My Mortgage?

If you’re still left wondering “should I refinance my mortgage?”, there are a number of reasons why refinancing your home could make sense.

You may choose to refinance in order to:

• Reduce your monthly payments: Your monthly payment will decrease if you refinance to a loan that lowers your interest rate or increases the number of years you have to pay off your mortgage.

• Lower your interest rate: If interest rates are lower than they were at the time you got your mortgage, refinancing can help you lock in a lower interest rate, so you pay less money in interest.

• Adjust your loan terms and pay the loan off faster: Want to switch from a 30-year mortgage to a 15-year mortgage? When you refinance, you can change the length of your loan.

• Eliminate private mortgage insurance (PMI), if you have it: If your home has increased significantly in value, refinancing and getting a new home appraisal might help you get rid of PMI.

• Switch from an adjustable-rate mortgage (ARM) to a fixed rate: If interest rates are lower, you may want to lock in a low interest rate with a fixed-rate mortgage to avoid the rate fluctuation you can see with an ARM.

• Take cash out: A cash-out refinance allows you to utilize your equity and have money on hand to consolidate and pay down your debt or complete some home renovations.

• Remove someone from the mortgage: This is typically an option for homeowners who’ve just gone through a divorce or have another reason to remove a name from their mortgage. A refinance may be a good idea if one spouse plans to purchase a new home or you’re looking for a way to divide assets.

Home Loan Refinancing FAQs

Does refinancing affect my credit score?

Applying to refinance may temporarily lower your credit score if the mortgage lender runs a hard inquiry on your credit report. When the lender pulls your credit score and history from a credit bureau to assess your standing, it’s considered a hard inquiry. This credit check can lower your credit score up to five points and may stay on your report for up to 2 years.  

How long does a refinance take?

On average, a refinance can take 30 – 45 days to complete. The refinancing process can take more or less time depending on home appraisals, inspections and other factors.

You can speed up the process by getting your credit score, debt-to-income (DTI) ratio and other qualification requirements in order. You can also gather any necessary documents, like W-2s and tax returns, prior to applying for a refinance. 

What does it cost to refinance?

Various costs are associated with refinancing a mortgage. Your lender will charge you closing costs, which may include an application fee, an appraisal fee, a title search fee and any attorney fees.

What’s the difference between a loan modification and a mortgage refinance?

A loan modification means that the terms of your original mortgage loan are changing, instead of paying off your existing mortgage and replacing it with a new one. A loan modification changes the conditions of your current mortgage directly, while a refinance gives you an entirely new mortgage to replace the old one.

What’s the difference between a second mortgage and a refinance?

Compared to a mortgage refinance, a second mortgage is a lien taken out against a property with an existing mortgage and, more specifically, the portion of the property you’ve already paid off. A lien grants the mortgage lender the right to seize your house under certain conditions, like a foreclosure.

A second mortgage allows you to borrow money against the equity you have in your home. Unlike refinancing, taking out a second mortgage doesn’t change your loan terms – even though you’ll likely pay more in interest on the second mortgage than on your current loan.

The Bottom Line

Refinancing your mortgage can be a great option if you’re looking to reduce your monthly payments, lower your interest rate or get rid of PMI. Some refinancing options – like a cash-out refinance – can also allow you to use cash from your home equity however you see fit, whether it be paying off debt, funding a home improvement project or making another type of investment.

Does a mortgage refinance make sense for your financial situation? Start the refinancing process with help from our team today.