How does refinancing a mortgage work? Essential tips for homeowners

What does it mean to refinance a mortgage?

“Mortgage refinancing” seems straightforward, right? In fact, the phrase “refinance” might sound like you can just call up your existing lender to make some changes to your current loan. Unfortunately, that’s not how it works.

To refinance a mortgage, you actually replace your existing home loan with an entirely new loan. Like when you applied for your original mortgage, you’ll want to make sure you have all the information that a lender may require.

Once you have been approved for and accepted a refinance loan, that loan will pay off your existing mortgage in full and take the place of your original mortgage. So you’ll still have a monthly mortgage payment, but it will be based on the terms of your new refinance mortgage.

What are reasons to refinance?

Whether mortgage refinancing is right for you is a personal decision based on many factors. But in general, people choose to refinance a home loan because the current lender or terms of their original loan no longer meet their needs. Because you cannot change the terms of your existing loan, refinancing may be one option to  make adjustments to the structure and conditions of your home loan.

1. You want a lower monthly mortgage payment

Regardless of loan type, your monthly payment includes a mix of principal and interest that you owe your current lender. If your goal is to lower your monthly mortgage payments, here are areas that refinancing might help:

• Loan amount: This is how much you borrowed from the lender. A refinance loan can be taken out for the amount that you still owe on the property—not the amount you’ve already paid off—which could lead to lower monthly payments than your existing loan.
• Mortgage term: This is your loan tenure (note that this is different than mortgage terms, which are the conditions that were outlined when you took the loan). A shorter mortgage term than your current loan means you agree to pay the loan off in less time, which may increase your monthly principal payment but reduce the total amount you’d spend in interest over the life of the loan. A longer mortgage term than your existing loan means that you’ll have the loan for more years, so you could pay less in principal each month but your total spend on interest could be greater. 
• Mortgage rate: Every monthly mortgage payment includes interest—and two big factors that may influence the home loan interest rate that you pay regardless of mortgage lender, loan type, or term: your credit rating and the interest rates set by the Federal Reserve (The Fed). If you have a fixed rate loan and your credit has improved or interest rates have decreased since you took your current mortgage, you might get a lower refinance rate and reduce the amount you pay the lender in interest.  
• Loan type (adjustable rate mortgage or fixed rate mortgage) also impacts how much you spend in interest. If you have a fixed rate mortgage, your monthly mortgage payments were likely calculated based on a few key factors at the time you applied for your original mortgage and are the same each month. If you have an adjustable rate mortgage (ARM), the interest rate can fluctuate over time and impact how much you pay each month. If interest rates have spiked after the initial fixed term of your ARM, your monthly payment might have skyrocketed and switching to a fixed rate loan could save you money.

2. You want to save money on interest

As we’ve seen, the mortgage rate is influenced by a lot of factors, some of which you can control and some of which you can’t. If you want to save money on the amount of interest you pay over the life of the loan and nothing else has changed, you may explore refinancing for a shorter loan tenure. If, however, your creditworthiness and/or broad economic conditions (The Fed’s interest rates, inflation or recession, policies, etc.) have changed, you should discuss your loan type and mortgage rate options with a mortgage broker.

3. You want more predictable expenses

As we’ve seen, an ARM may lead to rising expenses that are more than you are able to pay. Many people choose to switch to a fixed rate mortgage to enjoy the predictability of a monthly mortgage payment that is always the same.

4. You want to change the length of your loan term

Maybe you have decided to make your starter home a long-term investment property and are prepared to take out a longer-term loan so you can decrease your monthly payment. Or maybe your income has increased and you want to own your home outright more quickly, so you’d like to shorten the loan tenure, even if that means higher monthly payments. In either case, a mortgage refinance is likely required.

5. You want to consolidate debt or free up cash for other expenses

If you have large debt in other areas of your life, like medical bills or major unexpected expenses, a “cash out refinance” is a debt consolidation option that can help you pay off those creditors or get the funds you need to cover expenses like a home remodel or college tuition. 

What types of refinancing options are available?

There are typically two ways to refinance your current loan—remember, “refinancing” is when you take out a new loan with different terms and it replaces your existing mortgage. You can refinance with your current or a different lender, and it’s always a good idea to shop around to compare options. 

Mortgage refinance

If you’re just looking for lower interest rates, a lower monthly payment, or even a different length of time to pay off your home loan, a straightforward mortgage refinance is probably the choice for you. This involves taking a new home loan out for the amount that you still owe and using it to repay, and replace your original mortgage.

Cash out refinance

A “cash out refi” loan can be good refinancing option if you have other major expenses, and have built up equity in your property. “Equity” is the amount of your property that YOU own—not the lender—because you’ve either paid for it in cash (down payment) or even have paid off a portion of your existing mortgage. 

If you have accumulated a good amount of equity in your property you may be able to use that equity to borrow cash—so you’d take out a bigger loan (than what you currently owe on your home loan) that replaces your existing mortgage and gives you cash for the difference between the two. Learn more about cash out refinancing.    

How do I know if refinancing is right for me?

Whether refinancing is right for you is going to depend on your personal refinancing goals and whether it’s a good time to refinance. The best time to refinance a mortgage can be when you’ve owned your property and had that original home loan for at least six months, when you’ve built up home equity, when your credit score is strong, and when market conditions are favorable (your home value has increased, mortgage rates are down). 

Closing thoughts: How does refinancing work?