Refinancing: What is it and how does it work?

As you pay off your home loan, there may come a time when it makes sense to refinance your mortgage to better fit your financial needs or goals.¹ When you refinance, you pay off your original loan with a new loan that has more favorable terms. Refinancing your home loan can be a way to lower your monthly mortgage payment, reduce your interest rate, or borrow against your equity.

Here, we’ll walk you through how refinancing works and the different reasons to consider refinancing to help you decide if it’s the right move for you.

What does it mean to refinance your home?

You can think of refinancing the mortgage on your house as essentially trading in your current mortgage for a newer one – often with a new principal and a different interest rate. The newer mortgage pays off the old one, so you’re left with just one loan and one monthly payment and new terms.

There are a few pros and cons of refinancing, and there are cases when it makes sense and others when it doesn’t. Refinancing comes with up-front costs – 2% to 6% of the new loan amount, just like the closing costs you paid on your original mortgage. However, if refinancing allows you to reduce your interest rate considerably, you can recoup the closing costs and save thousands over the course of the term of the loan.

Reasons to consider mortgage refinancing

Let’s go over some of the most common reasons homeowners refinance and what it can allow you to accomplish.

Lower your interest rate

Interest rates are always changing. If market rates are lower now than when you got your loan, refinancing can help you get a lower interest rate and save money. Reducing the interest rate on your mortgage can not only reduce your monthly payment, it can also help you save on the total interest you pay. As a result, you can reduce the overall cost of your mortgage.

Lowering your interest rate by even just a fraction of a percent can save you thousands of dollars over the life of your loan. Just keep in mind that if your new loan term is extended, you may end up with lower monthly payments, but more years of payments could leave you with a higher overall cost.

Let’s look at the difference in the lifetime interest of two loans with a mere percentage difference in interest rate. This involves a 30-year fixed-rate loan of $350,000, with 3% closing costs on a refinance:

Of course, there are other factors beyond market rates that affect the new interest rate you’re offered. If your credit has improved since you took out your mortgage, that can work in your favor in lowering your interest rate. If your credit score has dropped, that can make it harder to get a lower interest rate.

Change your loan term

Another common reason to refinance is to either extend or shorten your loan term. If your monthly payments are too high, you can refinance to a longer term to lower your monthly payment. Just remember that paying more years of interest will increase the overall cost of your mortgage.

You can also refinance to shorten your loan term to save on interest. For example, say you started with a 30-year loan but can now afford a higher mortgage payment. You might refinance to a 15-year term to get a better interest rate and pay less interest overall.

Switch your loan type

You can also refinance to switch to a different type of home loan. Perhaps you originally got an adjustable-rate mortgage (ARM) to save on interest. With an ARM, your interest rate starts off low for a limited period, then adjusts on a recurring basis. Often, this means your interest rate increases and so do your monthly payments. You can refinance an ARM to a fixed-rate mortgage for more predictable monthly payments.

You can also refinance your FHA loan to a conventional loan and stop paying a mortgage insurance premium (MIP). If your credit has improved and you’ve built at least 20% equity, refinancing to a conventional loan can help you reduce your monthly payment.

One word of caution: Switching your loan type could change your mortgage insurance requirements and costs. That’s why if you consider this, it’s a good idea to as a professional about all the potential ramifications for your specific situation.

Cash out your equity

With a cash-out refinance, you borrow more than you owe on your home and pocket the difference as cash. If your home’s value has increased, you may have enough equity to take cash out for home improvement, debt consolidation, or other expenses. There are no restrictions on how you can use the money you borrow with a cash-out refinance. Just keep in mind this will increase the overall amount you owe, which can increase the amount you owe each month on your mortgage.

Using cash from your home allows you to borrow money at a much lower interest rate than other loan types. A cash-out refinance can have tax implications, though.

How to decide if refinancing is right for you

Refinancing is often a great way to lower your monthly payment, but it’s not an automatic win. There are a few things to consider other than just your monthly payment, such as how long it takes to recover your up-front costs and how any changes affect your long-term finances. Let’s take a closer look at three important factors.

The break-even point

One of the first things you’ll want to calculate is your break-even point. This is the month when your monthly savings wipe out the closing costs of refinancing. Here’s the simple formula:

Closing costs / monthly savings = break-even point

So, in our earlier example, the cost of refinancing – the closing costs – was $10,500. The monthly payment dropped by $229. So: $10,500 / $229 = 45.85 months.

This means that it will take 46 months, or nearly 4 years, to recoup the costs of refinancing. If you plan to stay in your home for at least 4 years, refinancing could be worthwhile.

The rate vs. term trade-off

Lowering your interest rate and monthly payment is a great feeling, but sometimes the loan term can matter just as much or more. It can even potentially wipe out any gains.

For example, say you have a 30-year fixed-rate loan and have been paying it down for 10 years. If you refinance into another 30-year fixed-rate loan, it resets the clock. You need to add the interest you’ve already paid for 10 years to the total interest you’ll pay on the new 30-year loan. That could turn out to be more than merely sticking with the original loan, despite a lower rate.

Conversely, if you switch to a lower interest loan but with a shorter term – 15 years for example – it could mean the same or even a higher monthly payment, but less interest paid over the life of the loan and help you build equity faster.

The point is, the term matters, as well as your payment history, along with monthly savings, and your personal goals. Each situation is unique.

Equity and loan-to-value (LTV)

Another factor that plays a major role in your refinancing decision is the amount of equity you have. The loan-to-value (LTV) is the ratio of your loan balance to your home’s value. For example, if you owe $350,000 on a $500,000 home, your LTV is 70%.

Lenders use LTV to assess risk when considering refinance loan applications. A lower LTV (more equity) often means lower interest rates, easier approval, and more loan options. A higher LTV typically results in fewer options, potentially higher rates, and possible mortgage insurance.

Generally speaking, you’ll want at least 20% equity – an 80% LTV or lower – to be in a strong position when refinancing and avoid mortgage insurance.

How to refinance a mortgage loan

The refinancing process is often less complicated than the home buying process, although it includes many of the same steps. Let's walk through each step of refinancing your mortgage.

1. Choose a refinance type

The first step is to review the types of refinance to find the option that works best for you. Many types of refinancing options exist, but here are some common ones borrowers consider:

• Rate-and-term refinance: This allows you to change the interest rate and term of your current mortgage. Reducing your interest rate can lower your monthly payment but may extend your loan term. Shortening your loan term can increase your monthly payment but save you money on interest.
• Cash-out refinance: You take out a new loan of a larger amount and receive the difference between the two loan amounts in cash. You can use this cash toward home improvements, paying down debt, or covering tuition costs.
• Cash-in refinance: This option allows you to pay a lump sum toward your mortgage to increase equity and decrease the amount owed. This can help you get a lower interest rate and monthly payment.
• No-closing-cost refinance: This allows you to roll your closing costs into the principal of the new loan instead of paying them in cash up front. This makes for a higher monthly payment, but reduces the cash required to close on the loan.
• FHA Streamline refinance: If you have a loan backed by the Federal Housing Administration, an FHA Streamline refinance² can help you lower your interest rate and monthly payment or switch from an ARM to a fixed-rate mortgage.

2. Research and choose a lender

You don’t have to refinance with your current lender, but you can if they offer you favorable terms. If you choose a different lender, that loan will pay off your original mortgage, ending your relationship with your old lender. Don’t be afraid to shop around and compare each lender’s current mortgage interest rates, availability, and client satisfaction scores.

Here’s a list of important things to check when shopping lenders:

• APR (annual percentage rate): This is the true cost of the loan, including (non-closing cost) fees that affect the rate.
• Lender fees: Origination fees, title insurance, property taxes, and other closing costs can vary significantly from lender to lender.
• Turnaround time: How quickly the lender can close your loan matters in times of rising rates.
• Service ratings: Does the lender have positive customer reviews, responsiveness, and overall customer experience?
• Rate lock options: How long can you lock your rate for, and are there float-down options if rates drop?

3. Gather documents and apply

Refinancing typically requires the same documentation you provided when you applied for your original mortgage. Your lender will need to review your income, assets, debt, and credit score to determine whether you meet the requirements to refinance and can pay back the loan.

Some documents your lender might need include the following:

• Two most recent pay stubs
• Two most recent W-2s
• Two most recent bank statements
• 1099s (if you’re self-employed)
• Profit-and-loss statements (if you’re self-employed)

You might be asked for more income documentation if you’re self-employed. It’s a good idea to have your tax returns from the last couple of years handy.

4. Lock in or float your interest rate

After you get approved, you may be given the option to either lock your interest rate – so it doesn’t change before the loan closes – or float your rate. Each option is unique and has its own pros and cons:

• Rate lock: Rate locks typically last 15 – 60 days. The rate lock period depends on a few factors like your location, loan type, and lender. If you’re happy with the rate you’re offered, it can make sense to lock it in. However, if your loan doesn’t close before the lock period ends, you may need to extend the rate lock, which can cost more.
• Float rate: You might also be given the option to float your rate, which means not locking it before proceeding with the loan. This may allow you to get a lower rate, but it also puts you at risk of getting a higher rate because it fluctuates.

5. Underwriting

During underwriting, your mortgage lender verifies your financial information and details about the property. Your lender will need to confirm that you have the income and assets to repay your new mortgage. Your lender will also verify your employment history and current credit score. If your credit has improved since you took out your initial mortgage, that can help you score a lower interest rate.

Be sure that you respond fully to any requests for documents in a timely manner. Not doing so can result in delays.

6. Get a home appraisal

Just like when you took out your original mortgage, the lender will order an appraisal to determine the property’s fair market value. The appraiser then visits your property and you receive a professional opinion of your home’s value. This figure will determine how much equity you have and what refinance options are available to you.

If you’re refinancing to take cash out, then the value of your home determines how much money you can get. If you’re trying to lower your mortgage payment, the value could impact whether you have enough home equity to get rid of private mortgage insurance (PMI) or be eligible for a certain loan option.

To prepare for the refinance appraisal, you’ll want to make sure your home looks its best. It’s also a good idea to put together a list of upgrades you’ve made to the home since you’ve owned it.

How you’ll proceed after the appraisal depends on whether:

The appraisal matches the loan amount: If the home’s value is equal to or higher than the loan amount, it means that the underwriting is complete. Your lender will contact you with details of your closing.

or

The appraisal comes back low: If you get a low appraisal, the loan-to-value ratio (LTV) on your refinance could be too high to meet your lender’s requirements. You can choose to decrease the amount of money you want to get through the refinance or cancel the application.

7. Close on your new loan

Once underwriting and the home appraisal are complete, it’s time to close on your loan. A few days before closing, your lender will send you a document called a Closing Disclosure that will contain the final terms of your loan.

The closing for a refinance is typically faster than the closing for a home purchase. At closing, you’ll go over the loan details, sign your loan documents, and pay your closing costs. If you’re doing a cash-out refinance, you’ll receive the funds after closing.

Once you’ve closed on your loan, you have a few days before you’re locked in. If something happens and you need to get out of your refinance, you can exercise your right of rescission to cancel any time before the 3-business day grace period ends.

FAQ about mortgage refinancing

Here are some more mortgage refinance tips and answers to common questions about refinancing.

What does it cost to refinance a mortgage loan?

The total cost to refinance depends on a number of factors like your lender and your home’s value. Expect to pay about 2% – 6% of the total value of your loan. You may not have to pay those costs out of pocket. In some cases, you can get a no-closing-cost refinance so you don’t have to bring any money to the table. Be aware that closing cost is then paid over the life of the loan in the form of a higher rate.

How long does it take to refinance a mortgage?

The time it takes to refinance can vary depending on your lender and financial situation. The typical timeline is 30 – 60 days, though it could take longer if there are issues with the appraisal or underwriting process.

Is it better to refinance or do a loan modification?

The major difference between a refinance and a loan modification is that refinancing gives you a new mortgage. Modification changes your current terms to add missed payments back into your balance with the goal of helping you stay in your home. A modification should only be considered if you can’t qualify for a refinance and need long-term payment relief. Modification typically has a major negative impact on your credit score.

Is a second mortgage the same thing as refinancing?

No, a second mortgage is not the same as refinance. When you refinance, a new mortgage replaces your existing loan. With a second mortgage, you take out another loan using your home as collateral, leaving you with a second loan payment each month. Second mortgages also come with more risk.

Can I reduce my monthly mortgage payment without refinancing?

If you’re interested in lowering your monthly payment, a mortgage recast is a straightforward option. It involves making a significant lump-sum payment on your principal so your lender can reamortize the balance.

How soon after closing can I refinance?

The answer depends on the type of loan you’re getting and the mortgage investor in your loan. It could be as little as 30 days and as long as 6 months or 1 year. How often you can refinance depends on the amount of equity built up and the current mortgage balance.

Will refinancing my home affect my credit?

When a homeowner refinances their mortgage, the lender pulls a hard inquiry and runs a credit report on the borrower’s history. This approval process will lower your credit score but only for a short period. As long as you don’t open any other credit cards and continue repaying any debts you have, your credit score can recover after a few months.

The bottom line: A mortgage refinance can make your home work for you

When the time is right, refinancing can be a great way to lower your interest rate and monthly payment or borrow against the equity you’ve built. You can also adjust your loan term or change your loan type.

Ready to refinance? Get started with Rocket Mortgage by checking out your refinance options and locking your rate today.

¹ Refinancing may increase finance charges over the life of the loan.

² Rocket Mortgage is not acting on behalf of FHA or HUD.

Rocket Mortgage is a trademark of Rocket Mortgage, LLC or its affiliates.