Refinance 101: The why, when, and how to refinance your mortgage

If you’re a homeowner, you may have heard about mortgage refinancing. Refinancing a mortgage can potentially save homeowners a substantial amount of money over the life of a home loan. But what exactly is mortgage refinancing, and how might it benefit you?

Mortgage refinance: What you need to know

• Mortgage refinancing involves replacing your current mortgage loan with a new one.
• Refinancing may help you save money on your monthly payments and interest over the life of your loan.
• Homeowners often choose refinancing as a way to take advantage of lower interest rates or to change the terms of an existing mortgage.

What is a mortgage refinance?

Mortgage refinancing is the process of replacing your existing mortgage with a new one. This can be done for various reasons, such as securing a lower interest rate, changing the length of the mortgage term, or tapping into your home’s equity. When you refinance your mortgage, you’re essentially taking out a new loan and using it to pay off your current mortgage.

Benefits

• Lower monthly payments. Refinancing to a lower interest rate may reduce your monthly mortgage payment, freeing up cash for other expenses or savings.
• Interest savings. Refinancing to a lower interest rate means you pay less interest over the life of the loan, potentially saving you thousands of dollars.
• Faster payoff. Refinancing to a shorter-term loan can help you pay off your mortgage faster and save on overall interest payments compared to your existing mortgage.
• Access to cash. A cash out refinance allows you to tap into your home’s equity for other financial needs.

Risks

• Closing costs. Refinancing may come with closing costs that you will have to pay, which can potentially add up to thousands of dollars. To avoid this, consider selecting a lender that offers to charge you no fees or cash due at closing.
• Longer loan term. If you refinance to a longer loan term, you might pay more interest over the life of the loan, even if your monthly payment is lower.
• Loss of equity. With a cash out refinance, you’re borrowing against your home’s equity, which can reduce the amount of equity you have available for future use.

Reasons to refinance your home

Here are more details about some of the reasons why you might choose to refinance.

1. Lower your monthly payment

If current interest rates are lower than the rate you are paying on your mortgage, refinancing could lower your monthly payment.

For example, if you took out a $250,000 mortgage at 10% for 30 years, your monthly payment (principal and interest) would be $2,193.93.*

If you were able to refinance to a 6.99% interest rate on a loan for 30 years once you paid your mortgage balance down to $200,000, your monthly payment (principal and interest) would drop to $1,329.26 — a reduction of more than $860 per month. Note that some of the reduction may be due to stretching out your payments rather than reducing your rate.

The longer you plan to stay in your house, the more money you may save by refinancing. However, consider that you will have to pay upfront closing costs because you are taking out a new mortgage.

Some lenders may tell you that rates must drop by at least 50 basis points (0.50%) for refinancing of the same loan term to make financial sense, but this threshold is different for everybody. The most important factor in your decision should be how long it takes to recoup the costs to refinance. If you expect to remain in your current home beyond the length of time it will take to recoup the costs, then it’s a good idea to consider refinancing your mortgage.

2. Switch to a shorter term loan

Depending on your situation, it could make sense to switch from a long-term loan to a short-term loan through a refinance. This might be particularly beneficial to you if you are now able to afford a higher monthly mortgage payment.

Switching from a 30-year loan to a 15-year loan results in higher monthly payments but pays the loan off much more quickly, saving thousands of dollars in interest payments over the life of the loan.

For example, a $100,000 loan at a 7% interest rate and a 30-year term will have a monthly payment of $665.30 but a total cost of $239,508.90 over 30 years.

However, the same $100,000 loan at a 7% interest rate with a 15-year term will come with a monthly payment of $898.83 and an overall cost of $161,789.09 over the life of the loan.*

3. Change from an adjustable-rate to a fixed-rate mortgage

Adjustable-rate mortgages (ARMs) are great for minimizing your monthly mortgage payment in the early years of owning a home. But when interest rates start to rise, so do the monthly payments on an ARM.

To avoid the increasing payments, you can switch to a fixed-rate mortgage. While the monthly payments on a fixed-rate mortgage may initially be higher than the payment on your ARM, you will have peace of mind knowing your payment will remain the same, even if interest rates continue to rise.**

5. Take cash out

When you have equity in your home, cash out refinancing can allow you to refinance your original mortgage and receive cash funds from your home equity at the same time. You might want to do a cash out refinance if:

• You want to make a large purchase but do not have access to other funding, or other loan options come with a higher interest rate than you can get with a refinance.
• You want to use equity from your home to consolidate other high-interest debt.

Some examples of what you can do with the equity you take out include:

• Making home improvements
• Purchasing an investment property
• Paying for higher education
• Paying credit cards, medical bills, or emergency expenses

When is the right time to refinance your home?

The right time to refinance your home depends on your individual circumstances and financial goals. Some factors to consider include:

• Interest rates. If current interest rates are lower than when you first took out your mortgage, it might be a good time to refinance. Depending on your circumstances, you may even find it beneficial to refinance your home multiple times.
• Credit score. A higher credit score may help you secure a better interest rate when refinancing. If your credit score has improved since you first took out your mortgage, it might be worth exploring your options for a refinance.
• Home equity. If you have built up the amount of equity in your home, you might consider a cash out refinance to tap into those funds for other financial needs.
• Length of time in the home. If you plan on staying in your home for a long term, refinancing might make sense because the savings may outweigh the costs.

If you’re wondering when not to refinance, there is generally one main reason to hold off: when you can’t get better rates or terms than you have on your existing mortgage. This might be due to details about your financial situation such as your credit score, income, debt-to-income (DTI) ratio, or loan-to-value (LTV) ratio with your current mortgage. However, it is possible that economic conditions at the time you’re looking to refinance have resulted in higher interest rates due to inflation or other factors.

Before you apply for a mortgage refinance, you may want to research market conditions and get an understanding of your personal financial situation. This way, you will have an idea of what you may be eligible for when working with a lender.

How does mortgage refinancing work?

The process of mortgage refinancing is similar to the process of obtaining your original mortgage.

1. Research and compare lenders. Shop around and compare interest rates, terms, and fees from multiple lenders to find the best refinancing option for your needs.
2. Submit a loan application. Once you’ve chosen a lender, you’ll need to submit a loan application and provide personal information as well as documentation such as pay stubs, tax returns, and bank statements.
3. Loan processing and underwriting. The lender will review your application and documentation, verify your income, and evaluate other information you provided to assess your ability to pay back the loan.
4. Appraisal. An appraisal may be required to determine the current value of your home.
5. Closing. Once the loan is approved, you’ll sign the new mortgage documents, and the new loan will be used to pay off your existing mortgage.

Closing thoughts: Mortgage refinancing 101

Mortgage refinancing may be a valuable financial tool for homeowners looking to lower their monthly payment, save on interest, or access their home’s equity. However, it is important to understand the benefits and risks and determine whether refinancing is the best choice for your unique financial situation. If you do decide to refinance, you will want to consider what might work best for your current and long-term financial goals before getting into the application process.