Mortgage Refinance: What Is It & How Does It Work?

How it works, the types of loans you can refinance, and the pros and cons of refinancing.

A mortgage refinance is the process of getting a new mortgage loan, with new terms, to repay your existing mortgage.

You might refinance to lower your interest rate, or to change the terms of your loan, such as moving from an adjustable rate to a fixed rate. You can also refinance to take cash out of your home equity to use for things like repaying other debts or home improvement projects.

This article will explain what mortgage refinancing is, how the process works, the types of loans you can refinance, and the pros and cons of refinancing your home loan.

What Does it Mean to Refinance?

Most mortgages are paid off over a relatively long time (15 or 30 years). During that time, you may want to change the terms of your loan, if it brings you some benefit. You also build up equity in your home over time as you make payments and as your property goes up in value. Equity is the value of your home, minus your current mortgage. You may want to pull some of this money out of your house for other purposes, because borrowing against home equity is one of the least expensive ways to borrow money. A mortgage refinance allows you to do these things.

When you refinance, you apply for a new loan, either with your current lender or a different one. You could borrow just enough to pay off your current loan or borrow a little more money if you're trying to take the equity out of your home.

You'll need to apply for a mortgage refinance loan, and once you're approved and get the loan, your existing mortgage will be paid off. Any extra money you borrow will then be given to you to use for whatever you'd like, such as paying for home improvements or repaying other higher-interest debt.

You'll begin paying on your new home loan at this point, under your new terms. Depending on the interest rate change, the term of your new loan, and how much money you took out of your home, your new payment may be higher or lower than your old one.

How Does Refinancing Work?

When you refinance a mortgage loan, you first must determine how much you want to borrow. This decision is a key part of learning how refinancing works, and it will be based on your goals for the loan (the reason you are refinancing your mortgage).

• If you're refinancing to take cash out of your home for home improvements, debt payment, or for other goals, you should calculate how much it costs to repay your current loan and also get the amount of extra money you need.
• If your goal is just to change your current loan but not get extra money out, you will borrow just enough to repay what you owe and, sometimes, to cover closing costs you pay during refinancing. It’s very common for people to roll closing costs into their new mortgage when refinancing.

Once you know the amount you need to borrow, look for a trusted lender offering a good rate and other favorable terms on a mortgage refinance loan. Then, go through the application process. This process will be very similar to when you applied for the mortgage to buy your home. You can expect your lender will:

• Check your credit to make sure your score meets the standards for refinancing mortgage loans.
• Review all of the financial documentation necessary for refinancing a mortgage, including your bank statements, pay stubs, and investment account statements. This information is typically part of each mortgage option’s guidelines that are designed to make sure your finances are in good shape to refinance and that you can afford your new mortgage payment.
• Make sure your house qualifies for a refinance. This means appraising the home to make sure its value is high enough to guarantee the loan. For example, if your new mortgage’s guidelines only allow you to borrow 80% or 90% of your home's value, the lender needs to know what that value is and compare it to the amount you want to borrow.

If your lender is confident that you have the money to comfortably afford to repay a new loan and that your home is worth enough to be the collateral that protects them from loss, then you'll be approved for the refinance loan.

This process usually takes several weeks, although it can vary depending on the lender and how complicated your financial situation is.

Mortgage Refinancing Types

There are different kinds of mortgage refinance loans that you may be interested in when you are trying to refinance your home loan. Here are three of the most common types.

There are other options too, such as reverse mortgages or short refinance loans. However, these three types of loans are very common, and most people find one of these options works for them.

How to Refinance a Home

If you're going to refinance a home, here are the steps you'll most likely take during the process.

• Decide what your goal is for refinancing: Are you hoping to lower your interest rate? Do you want to switch from an adjustable-rate mortgage to a fixed-rate loan to get more certainty about future borrowing costs? Do you need to take equity out of your home? Think about your goals so you can decide how refinancing will help you accomplish them.
• Review your credit score: Most lenders require at least fair or good credit to qualify for a mortgage. You can check your credit score online to see if you'll qualify for a refinance loan (although your lender may tell you a slightly different number than you found when they pull your credit). It's also a great idea to check your credit report for accuracy, which you can do for free at AnnualCreditReport.com. If you spot errors in your report, you can dispute them. Also, if your credit score isn't as high as you'd like, you can look into raising your score by paying off debt and making all your payments on time. You might be surprised how quickly your score rises.
• Choose a refinance option: Based on your goals, you'll need to decide whether you want a conventional refinance loan, a cash-out refinance loan, or a streamlined refinance loan. Your lender can help you decide which makes the most financial sense to help you reach your goals. You'll also want to think about your loan term. The two most common are a 30-year loan, which has a longer payoff time and higher interest costs over time but lower monthly payments; or a 15-year loan, which has a lower rate and much lower total interest costs but much higher monthly payments.
• Select a lender: You should find a lender that you trust and that offers the type of loan you want at a good interest rate, and make sure you meet their qualifying requirements. Many problems can happen with a poorly planned mortgage, so never work with a lender that doesn’t have a history of satisfied customers or that isn’t recommended by someone that has used them in the past.
• Gather and organize your financial documents: Your lender will ask for information to verify details about your finances. Gather (or have access to) tax returns, pay stubs, current mortgage statements, property tax bills, and homeowners insurance statements so your lender will get a complete picture of your financial situation.
• Apply for your refinance loan: You'll then need to submit all of your financial information as part of your mortgage refinance application, and any additional information your lender may need based on your type of mortgage.
• Secure your interest rate: Your lender will review your financial details and let you know how low of an interest rate you qualify for. Your rate will ideally be lower than the rate on your current loan. However, there are times when it makes sense to refinance at a higher rate, such as when you are switching from an adjustable to a fixed-rate mortgage, so you won't have to worry about rate increases moving forward.
• Complete the underwriting process: Once you know your rate and are ready to move forward with borrowing, you'll go through the underwriting process. Here, professionals who assess risk for a living will take a close look at your application to make sure you meet all qualifications for your mortgage. If all your financial documentation checks out and can be verified, your loan will move forward.
• Get ready for your home appraisal: A home appraisal is a key part of most refinance loans because lenders need to make sure your home is worth enough to guarantee the loan. Lenders typically won't lend you more than 80% - 90% of your home's value. So, if you hypothetically had a $100,000 house, your lender might only be allowed to lend you 80% of its appraised market value. The appraisal lets lenders know what your market value is, so they know how much to loan you. You want to get ready by making your house look its best. This may include cleaning up clutter and making minor repairs. Most importantly, don’t start major home renovations that aren’t completed before your appraisal.
• Make closing cost payment: If your home appraises for enough and the underwriting gives final approval, it's time to close on the loan. This means you'll need to pay closing costs or upfront fees that come with refinancing. These fees cover things like title insurance and credit report charges. Your lender will tell you exactly what your closing costs are. As mentioned, it’s very common to roll these into your new loan except in cases when your equity can’t cover the additional closing costs (typically 3% to 6% of your loan amount)
• Finalize the new loan: Finally, you will sign your new loan paperwork. Your new loan will pay off your old one. If you take cash out, you'll receive the money. Then, you'll start begin paying off your new mortgage loan, building equity with every payment.

Is it a Good Idea to Refinance a Mortgage?

Refinancing your mortgage can make a lot of sense under the right circumstances, but whether you should refinance or not depends on your situation.

Refinancing is a good idea if:

• You have a lot of equity in your home, and you need some money for other things like paying off more expensive debt or improving your house. Refinancing can allow you to access some of the money trapped in your house to be put to good use at low interest rates, compared to personal loans or home equity loans.
• You can get a better interest rate to save on borrowing costs. If you can reduce your rate, then more of each monthly payment can go towards reducing your balance (or for whatever you want each month). You can save on interest not only each month but also during the life of the loan.
• You need to change your loan type. If you have an adjustable-rate mortgage (ARM), there's a change your rate could increase over time. If you refinance, you can switch to a fixed-rate loan that will provide you with more certainty in payment costs through the life of your loan. This is especially important if your ARM will soon start adjusting.
• You need to change your loan terms. You may want to change other things about your loan, such as how long you have to pay off the debt. If you refinance to a new mortgage with a longer repayment time than your current loan, you can reduce your payment. You'll pay more total interest over time, but many people still prefer the flexibility of having a lower required monthly payment. And you can always pay extra each month toward principal if that fits your budget, which will reduce the total interest you pay and the length of the loan with each extra payment.

Refinancing makes sense for a lot of people, especially if you can get a refinance loan at a low rate to pay off costlier debt or if you are changing your loan type or terms to provide more financial stability going forward.

There are also some downsides, though. Refinancing may not be a good plan for you if:

• You have a very low interest rate on your current loan, and you don't want to lose it. Rates during the pandemic era hit record lows, so cash out refinancing in the post-pandemic era could mean you get stuck with a higher rate. A home equity loan might make more financial sense in this scenario.
• You want to be debt-free ASAP. Refinancing usually extends your payment time. If you have a 30-year mortgage you've been paying for five years and you refinance to a new 30-year loan, you've just added five years to your debt-free date.
• You don't want to pay the costs of refinancing. Closing costs can add up to several thousand dollars, and you either need to pay these costs or roll them into your loan (which means you'll be paying interest on them and paying them off over many years).
• You aren't confident you can make the new payments. If you are considering a cash-out refinance loan but aren't sure you'll be able to comfortably make the payments after you increase your loan amount, you could put your house at risk of being lost to foreclosure.

You should always carefully consider the pros and cons of refinancing to decide if it is right for you.

Mortgage Refinancing FAQs

If you still have more questions about refinancing, here are the answers to some frequently asked questions.

How Much Equity Do You Need to Refinance?

The amount of equity you need to refinance depends on your lender's policies, the amount you currently owe on your mortgage, and the amount of your planned future loan.

Most lenders don't want your total borrowed amount to be more than 80% or 90% of your home's value. So, if you had a $100K home, you'd need at least $20K in equity in the house to be able to refinance so your loan wouldn't go above 80% of your home's $100,000 value.

How Much Does It Cost to Refinance a Mortgage?

Closing costs average 3% to 6% of the balance being refinanced, according to the FHA.

How Quickly Can I Refinance After Closing?

The rules for refinancing after closing vary by lender. You may be able to refinance shortly after you close on your loan, but you don't want to refinance too often because refinance fees will eat away at any savings your new loan provides. Some types of loans also require a six-month waiting period before you can refinance again.

Does a Second Mortgage Count as a Refinance?

A second mortgage is different from a refinance. A second mortgage involves getting a new loan that is also guaranteed by your home. This new loan is in addition to your existing loan. Your current mortgage is usually not affected. By contrast, refinancing involves getting a new loan to replace the original loan you currently have.

Looking to Refinance Your Mortgage? Let Us Help!

Refinancing a mortgage can be a great choice in the right circumstances, but you need the right lender to make it happen.

Freedom Mortgage has helped many clients successfully refinance their homes using a conventional refinance loan, cash-out refinance loan, or FHA streamlined refinance loan.

Give us a call today to learn how we can help you explore whether refinancing your mortgage will fit your financial goals and how much money you can save.