Refinancing a mortgage means securing a new loan to replace your existing home loan.1 Before embarking on this process, it’s crucial to understand how it functions, along with its potential advantages and disadvantages.
Continue reading for a comprehensive guide on how mortgage refinancing works, including the steps to refinance your home and how to determine if it’s a suitable financial decision for you.
How Mortgage Refinancing Operates
Refinancing a home loan entails substituting your current mortgage with a new one. The primary goal of mortgage refinancing is typically to secure more favorable terms or to access your home equity through one of these common refinance types:
- Rate-and-term refinance: Often referred to as a traditional refinance, this option allows you to reduce your interest rate or monthly payment, or to accelerate your home payoff by shortening the loan duration.2
- Cash-out refinance: This loan enables you to convert a portion of the equity you’ve accumulated in your home into cash by taking out a new, larger mortgage.3
Generally speaking, refinancing your mortgage could be a smart move if you are able to qualify for a lower interest rate than what you currently have. Conversely, it might be a less attractive option when prevailing interest rates are higher than they were when you originally took out your home loan.
Tip: You can also use a refinance to make a substantial upfront payment on your mortgage, known as a “cash-in” refinance. This can be an astute strategy to pay off your mortgage more quickly, save on interest, and reduce your monthly payments if you’ve recently received a significant sum of money.
Steps to Refinance a Mortgage
The process of refinancing a home loan is quite similar to the steps you followed when you first obtained your original mortgage. Here’s a breakdown of the steps involved in refinancing a mortgage:
- Evaluate Your Financial Standing
The eligibility requirements for refinancing a mortgage are comparable to the criteria for a new mortgage loan. Lenders will evaluate several aspects, including your:
- Credit history and score
- Payment history on your existing loan
- Income and employment stability
- Equity built up in your home
- Current market value of your home
- Other outstanding debt obligations
Therefore, you should assess your position in each of these areas to determine your eligibility. For example, if you possess an impeccable credit history, a steady income, and substantial home equity, you’re likely to be approved for more advantageous terms on a new loan.
However, if your credit score has declined since you obtained your first mortgage, or if your overall debt has increased, you might face more difficulty securing favorable terms.
- Explore Options
Undergo the preapproval process with multiple mortgage lenders. This allows you to compare different interest rates and other terms, maximizing your chances of finding the most suitable offer available to you.
Tip: Beyond simply comparing refinance offers against each other, it’s also important to compare the proposed terms with your current mortgage loan terms. This comparison can help you ascertain whether refinancing is indeed the right decision for you.
- Perform Calculations
Once you’ve identified the most appealing offer, compare the potential savings against the potential costs.
Example: If refinancing your loan with a new lender incurs $5,000 in upfront costs, and your new monthly payment is only $100 less than what you were paying before, you would need to remain in the home for at least 50 months to make the refinance financially worthwhile.4
If you don’t intend to stay in the home for an extended period, refinancing might not be the best course of action. Use a mortgage calculator to run the numbers and compare potential new loan options with your current mortgage. Then, weigh how much you might save from refinancing against the upfront lender fees to gauge whether it’s a financially advantageous move.
Mortgage Calculator
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Tip: Be vigilant for conditions like prepayment penalties, which can create issues later if you decide to pay off your existing mortgage early or refinance again.
- Submit Your Application
When you’re prepared to submit an official application, you’ll do so directly with your chosen lender. You’ll need to provide detailed information about yourself, your property, and your current mortgage loan.
You will also be required to furnish documentation for various aspects of the application. Potential documents you might need to submit include:
- Recent pay stubs
- W-2 forms
- Bank statements
- Tax returns
- Business income statements
- Investment account statements
- Alimony and child support information, if applicable
- Photo identification
- Proof of legal U.S. residency
- Sources of funds
- Gift letter, if applicable
On average, this process can take around 48 days from the application date to the closing date, according to ICE Mortgage Technology.5 However, some lenders may promise shorter closing times.
Learn more: Checklist of Documents You’ll Need for a Mortgage
- Finalize Your Loan at Closing
Once the lender is ready to finalize the loan, you will gather to sign the necessary paperwork to make the new loan official. Subsequently, the lender will pay off your original loan and establish an account for your new mortgage.
If you are pursuing a cash-out refinance, you will receive the cash either as a check or a wire transfer.
5 Reasons to Refinance a Mortgage
Homeowners opt to refinance their mortgage loans for several key reasons. Here are some of the primary ones to consider:
- Reduced interest rate and payment: If your credit standing has improved or market rates have fallen since you obtained your initial loan, you may be able to save money on interest with a lower rate and corresponding monthly payment. This can be achieved through a rate-and-term refinance.
- Switch interest rate type: Another possibility with a rate-and-term refinance is to convert your loan from an adjustable rate to a fixed rate, which can help insulate you from market fluctuations.6
- Adjust the loan term: You can often qualify for a lower interest rate by shortening your loan term (e.g., from 30 years to 20 or 15 years) via a rate-and-term refinance. Doing so can also result in significant interest savings over the loan’s lifetime, though it typically entails higher monthly payments. Conversely, by extending your loan term, you can potentially lower your monthly payment.
- Access cash from your home equity: If you possess substantial equity in your home, you might use a cash-out refinance to tap into some of that equity. Homeowners commonly do this to consolidate debt, finance a significant purchase, invest, or buy out a former spouse in a divorce settlement.
- Reduce your outstanding balance: A less common refinancing option is a “cash-in” refinance. Instead of withdrawing cash, you refinance your loan and contribute cash to reduce the principal balance. You might consider this if you are underwater on your loan or wish to eliminate private mortgage insurance.
Learn more: When Should You Refinance Your Mortgage?
Disadvantages of Mortgage Refinancing
As you weigh the reasons for refinancing your mortgage loan, it’s equally important to consider the potential drawbacks of the process, including how refinancing can impact your credit. Here’s what you should contemplate before initiating the process:
- Increased total interest: Lengthening your loan term can lead to paying more interest over the entire life of the new loan.
- Potential for higher payments: Cashing out a portion of your equity will increase the loan amount on your new mortgage, which could result in a higher monthly payment.7
- Potentially costly closing costs: If you intend to sell your home before you reach the break-even point on your closing costs, it might be more sensible to maintain your current mortgage.
- Market conditions can limit options: There’s no guarantee that you will secure better terms on the new loan. This is especially true during periods when interest rates are rising.
- Loan resets: You will be replacing your current mortgage loan—and any remaining time until it’s paid off—with an entirely new mortgage.8 Depending on how long you’ve had your current mortgage and the duration of your new mortgage, you are likely extending the total number of years you will be making mortgage payments.
- Impact on credit history length: This factor, which constitutes 15% of your FICO® Score, could be negatively affected when your old mortgage loan is closed and replaced with a brand new one.
- Missing a payment could harm credit: Your credit score could drop if you miss a payment on your old loan during the refinancing process. Ensure you continue making payments until your old loan’s balance is zero.
- Hard inquiries can affect credit: Applying for a mortgage loan will result in a hard inquiry on your credit report, which can temporarily reduce your credit scores by a few points. Multiple credit inquiries within a short timeframe (typically 14 to 45 days) are usually treated as a single inquiry on your credit report. However, if you shop for rates over several months, your scores could be negatively impacted by multiple inquiries.
Learn more: Reasons Not to Refinance Your Home
Frequently Asked Questions
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Monitor Your Credit Before and During the Refinance Process
As you consider and apply for a refinance loan, it’s critical to be aware of your credit standing. Regularly check your FICO® Score to avoid being caught off guard by negative or incorrect information. Additionally, try to avoid taking out new credit both before and during the refinance process, if possible. Doing so can help prepare your credit for the process and also allow you to identify any potential issues that could affect your approval until closing.