How Does Refinancing a Mortgage Work?

For many, the thought of a mortgage means being tied to payments for several decades. However, this isn’t always the case. You might find that refinancing your mortgage could provide more suitable terms for your current circumstances.

Before proceeding, it’s vital to grasp the intricacies of mortgage refinancing and its potential costs. Let’s delve into the specifics of this process.

Key Takeaways

Mortgage refinancing involves substituting your existing home loan with a brand-new one.
While smaller monthly payments can ease your budget, they typically extend the duration of your debt.
Refinancing into a shorter loan term can lead to long-term savings, but it means facing higher monthly payments.

What is Mortgage Refinancing?

Mortgage refinancing functions by replacing your current home loan with a completely new financing agreement. Instead of merely altering the conditions of your present mortgage, you secure an entirely fresh loan. This new loan, often referred to as a mortgage refinance, is then used to pay off your old mortgage.

Upon obtaining your new mortgage, you will commence making payments on this updated loan. Depending on your financial situation, your new mortgage could also encompass any second mortgages or home equity lines of credit (HELOCs) you currently hold. It’s possible to consolidate all your existing mortgages—and even other outstanding debts—into a single new loan through the refinancing process.

How Does Refinancing Work?

The refinancing procedure is quite similar to the steps involved in obtaining your original mortgage. You’ll be required to submit an application and undergo a credit check. Furthermore, you’ll need to provide documentation verifying your income and identity, much like what you presented during your initial mortgage application.

However, the new mortgage terms might offer more advantageous conditions for you. Mortgage refinancing has the potential to result in:

A reduced interest rate, consequently leading to lower monthly payments (assuming all other factors remain constant).
A shorter loan duration, if that is your preference.
A substantial sum of cash at your disposal (if you opt for a cash-out refinance, which will be explained further below).

When refinancing, you must also anticipate various fees. Just as your initial mortgage came with associated costs, your refinance will incur additional expenses. (Note: Some refinancing promotions might claim “no cost” to you, but typically these costs are embedded elsewhere. More on this below.)

It’s crucial to ensure that any financial benefits derived from mortgage refinancing adequately compensate for these associated costs.

What is Cash-Out Refinancing?

Cash-out refinancing is a specific type of mortgage refinance that enables you to borrow an amount greater than your existing mortgage balance and retain the difference in cash.

For instance, imagine you have an outstanding balance of $250,000 on your current mortgage, and your home is appraised at $400,000. You decide to pursue a cash-out refinance. In many cases, you can secure a cash-out refinance that ensures you retain at least 20% equity in your home (meaning an 80% loan-to-value, or LTV, ratio).

So, your lender might approve a mortgage for 80% of the $400,000 appraised value, which amounts to $320,000.

Assuming you desire the maximum LTV loan, at the time of closing, $250,000 will be used to pay off your original mortgage, and the remaining $70,000 will be disbursed to you (after deducting any closing costs and fees imposed by your lender). You will then commence making payments on this new, larger loan amount.

You have the flexibility to use that $70,000 for any purpose you choose, whether it’s funding a child’s college education, eliminating credit card debt, or covering wedding expenses.

However, it’s vital to recognize that with a cash-out refinance, you are leveraging your home as collateral for whatever you spend the money on. Should you later become unable to make your payments, you risk losing your home. Before proceeding, ensure you can comfortably afford the increased payments and that the use of the cash aligns with your broader financial objectives.

Should I Refinance My Home?

There are various scenarios to weigh when considering whether to refinance your home. Mortgage refinancing offers distinct advantages, but it’s essential that these align with your specific financial goals. Here are common reasons why homeowners opt to refinance:

Lower Interest Rate. One of the most compelling reasons to refinance is to secure a lower interest rate. If you currently hold a variable-rate mortgage, refinancing to a fixed rate can help you avoid increases in your monthly payment should interest rates rise.
When you refinance to a lower interest rate, you can potentially reduce your monthly payment. You generally have two primary options when pursuing a lower rate:
- Maintain the Same Term: Refinance while keeping your original loan schedule. For example, if you have 20 years remaining on a 30-year loan, you could refinance to a lower interest rate, but instead of obtaining a new 30-year fixed-rate mortgage, you’d get a 20-year mortgage.
- Opt for a Longer Loan: Further reduce your monthly payment by securing a new 30-year fixed-rate mortgage. This can improve your monthly cash flow, but it means being in debt for an additional 10 years.
Let’s consider an example. Suppose your current monthly payment is $1,703 with an interest rate of 5.5%. You have $250,000 remaining on your mortgage and are considering refinancing. Assume the rate for a 20-year fixed mortgage is 4.0%, and for a 30-year fixed, it’s 4.3%. Typically, longer-term mortgages carry higher interest rates—this is known as a “normal” yield curve.

If you refinance to a 20-year term, your new monthly payment would be $1,515, resulting in total interest savings of $45,132.

If you refinance to a 30-year term, you’d enjoy a significantly lower payment of $1,237, but you would pay nearly $82,000 more in interest over the full life of the mortgage. Ouch!

Extending the duration of your mortgage can lead to a higher overall cost, even if it improves your monthly cash flow. Understanding this trade-off is critical when deciding whether to refinance.

Loan Calculator

Want to experiment with the numbers yourself? Simply input the loan amount, term, interest rate (with compound and payment frequency set to monthly), and calculate.
Accelerate Your Home Loan Payoff. Perhaps your goal is to pay off your mortgage sooner, achieving debt freedom at an earlier age. Using the same figures as before, what if you decide to refinance into a 15-year term and eliminate your mortgage five years ahead of schedule?
At 4%, your new monthly payment would be approximately $1,849.22. While this is about $146 more than your pre-refinance monthly payment, you would be mortgage-free five years sooner and save almost $76,000 in interest (compared to your current mortgage). That’s a significant amount of money that stays in your pocket instead of going to your lender.

Just ensure you can comfortably manage the higher payment. If you’re concerned, a smart strategy employed by some savers is to take the longer-term mortgage but make additional principal payments each month. This way, you still pay off the mortgage faster and save on interest, but you’re not locked into the higher mandatory monthly payment. Should you encounter a financial crunch, you can revert to the required payment, reducing the risk of falling behind.

A Note on Refinancing Costs

Before deciding whether to refinance your house, be sure to factor in the associated expenses. Just like your original mortgage, a refinance comes with its own set of fees and costs. According to Freddie Mac, closing costs on a refinance average around $5,000. Some typical costs you might encounter during a mortgage refinance include:

Origination fees
Underwriting fees
Appraisal fees
Credit report fees
Attorney fees
Title fees
Government recording costs
Various service fees

If your closing costs amount to $5,000, the time it takes to recoup that amount through monthly savings depends on your new mortgage terms:

20-year refinance: Approximately 27 months
30-year refinance: Approximately 10 months

Your lower monthly payment with a 30-year refinance allows for a quicker recovery of costs based on cash flow savings. However, remember that you’ll pay more in overall interest. Conversely, with a 15-year refinance, you won’t recoup costs as quickly through monthly payment savings, but the substantial total interest savings make it financially worthwhile from a strict numerical perspective.

Be cautious of “no-cost” refinances. Some lenders advertise “no-cost” refinancing, but proceed with caution. It might be labeled “no-cost” because you aren’t paying anything upfront. Instead, the fees could be rolled into your mortgage, making your loan slightly more expensive. Other lenders might genuinely waive costs but compensate by offering a higher interest rate—ultimately costing you more each month over time.

The Bottom Line

Before making a decision on mortgage refinancing, ensure you evaluate it within the context of your overarching financial objectives. How long do you anticipate remaining in your home? Are you comfortable with paying more overall interest, or would you prefer to become debt-free sooner? As a related point, are you able to claim mortgage interest as a tax deduction, or do you utilize the standard deduction?