Mortgage refinance: What is it and how does it work?

Whether you’re looking to get a lower interest rate or tap your home equity to complete renovations, a refinance might be in your near future for many reasons. Understanding how refinancing a mortgage works, the options available, and the pros and cons to consider will help you determine if a refinance is the right move.

What is refinancing?

Refinancing is a strategy lenders and borrowers use to replace an existing mortgage with a new one. Borrowers often refinance to change their original mortgage’s interest rate or loan terms. You can refinance with your current lender or work with a different one.

How does refinancing work?

When you refinance your home, you’ll apply in a similar way to when you applied to purchase your home. In many ways, the process is like a less strenuous version of getting a purchase mortgage. Here’s generally how it works:

• The lender will do a credit check.
• You’ll turn in any required financial documentation.
• You’ll pay for a home appraisal.
• The loan will go through the mortgage underwriting process.
• The process will be completed in an average of 30 to 45 days.

Types of mortgage refinance

There are many types of refinancing, so consider each within the context of your unique financial situation. Your goal might be to adopt a shorter loan term, or maybe your focus is to lower monthly payments. Here’s a breakdown of each.

• Rate-and-term refinance
  

  A rate-and-term refinance changes either the loan’s interest rate, the loan’s term or both.

• Cash-out refinance
  

  When you do a cash-out refinance, you use your home equity to withdraw cash to spend. This increases your mortgage debt but gives you money that you can invest or use to fund a goal, like a home improvement project.

• Cash-in refinance
  

  With a cash-in refinance, you make a lump sum payment to reduce your loan-to-value (LTV) ratio, which cuts your overall debt burden, potentially lowers your monthly payment and also could help you qualify for a lower interest rate.

• No-closing-cost refinance
  

  A no-closing-cost refinance is a type of low-cost refinance that allows you to refinance without paying closing costs upfront. Instead, you roll those expenses into the loan, which means a higher monthly payment and likely a higher interest rate.

• Short refinance
  

  If you’re struggling to make your mortgage payments and are at risk of foreclosure, your lender might offer you a short refinance. In this type of refinance, your new loan is lower than the original amount borrowed, and the difference is forgiven.

• Reverse mortgage
  

  You might be eligible for a reverse mortgage if you’re a homeowner aged 62 or older. This type of mortgage allows you to withdraw your home’s equity and receive monthly payments from your lender. You can use these funds as retirement income, to pay medical bills or for any other goal.

• Debt consolidation refinance
  

  Like cash-out refinances, debt consolidation refinances give you cash. But there’s one key difference: You use the cash from the equity you’ve built in your home to repay other non-mortgage debt, like credit card balances.

• Streamline refinance
  

  A streamline refinance accelerates the process for borrowers by eliminating some refinance requirements, such as a credit check or appraisal. It’s available for FHA, VA, USDA and Fannie Mae and Freddie Mac loans.

How to refinance your mortgage

What happens when you refinance your home or rental property? Refinancing is similar to the purchase mortgage application process: The lender reviews your finances to assess your risk level and determine your eligibility. Here’s what you can expect:

• Set a clear financial goal
• Check your credit score and history
• Determine how much home equity you have
• Shop multiple mortgage lenders
• Get your paperwork in order
• Prepare for the home appraisal
• Come to the closing with cash, if needed
• Keep tabs on your loan

Step 1: Set a clear financial goal

There should be a good reason why you’re refinancing a mortgage, whether it’s to reduce your monthly payment, shorten your loan term or pull out equity for home repairs or debt repayment.

What to consider: If you reduce your interest rate but restart the clock on a 30-year mortgage, you might pay less every month, but you’ll pay more over the life of your loan in interest.

Step 2: Check your credit score and history

You’ll need to qualify for a refinance just as you needed to get approval for your original home loan. The higher your credit score, the better refinance rates lenders offer you — and the better your chances of underwriters approving your loan. For a conventional refinance, you’ll need a credit score of 620 or higher for approval.

What to consider: While there are ways to refinance your mortgage with bad credit, spend a few months boosting your credit score, if you can, before you contact lenders for rates.

Step 3: Determine how much home equity you have

Your home equity is the total value of your home minus what you owe on your mortgage. Check your latest mortgage statement to see your current balance and figure it out. Then, check home search sites or have a professional appraisal to estimate your home’s value. Your home equity is the difference between the two. For example, if you still owe $250,000 on your home, and it’s worth $325,000, your home equity is $75,000.

What to consider: You’ll get better rates and fewer fees (and won’t have to pay for private mortgage insurance) if you have at least 20 percent equity in your home. The more equity you have in your home, the less risky the loan is to the lender.

Step 4: Shop multiple mortgage lenders

Getting quotes from at least three mortgage lenders can help you maximize your savings when refinancing a mortgage. Once you’ve chosen a lender, discuss when it’s best to lock in your rate so you won’t have to worry about rates climbing before your refinance closes.

What to consider: In addition to comparing interest rates, pay attention to the various loan fees and whether they’ll be due upfront or rolled into your new mortgage. Lenders sometimes offer no-closing-cost refinances but charge a higher interest rate to compensate.

Step 5: Get your paperwork in order

Gather recent pay stubs, federal tax returns, bank/brokerage statements and anything else your mortgage lender requests. Your lender will also look at your credit score and net worth, so disclose all your assets and liabilities upfront.

What to consider: Have your documentation ready before refinancing a mortgage to make the process go more smoothly and often faster.

Step 6:  Prepare for the home appraisal

Mortgage lenders typically require a home appraisal (like when you bought your house) to determine its market value. A professional appraiser will assess your home based on criteria and comparisons to the value of similar homes recently sold in your neighborhood.

What to consider: You’ll pay a few hundred dollars for the appraisal. Let the lender or appraiser know of improvements, additions or major repairs you’ve made since purchasing your home. This could lead to a higher refinance appraisal.

Step 7: Come to the closing with cash, if needed

The closing disclosure and the loan estimate list the closing costs to finalize the loan.

What to consider: You might be able to finance the costs, which can amount to a few thousand dollars, but you will likely pay more for it through a higher interest rate or total loan amount. Do the math for yourself, but know that it often makes more financial sense to pay closing costs upfront if you can afford to.

Step 8: Keep tabs on your loan

Some lenders give you a lower rate if you sign up for autopay. Store copies of your closing paperwork in a safe place.

What to consider: Your lender or servicer might resell your loan on the secondary market either immediately after closing or years later. That means you’ll owe mortgage payments to a different company, so keep an eye out for mail notifying you of such changes. The loan terms themselves shouldn’t change, though.

Pros and cons of mortgage refinance

Pros

• You could lock in a lower interest rate.
• You could lower your mortgage payment and create more space in your monthly budget.
• You could decrease your loan’s term and pay it off sooner.
• You could tap into your home’s equity and take cash out at closing.
• You could consolidate debt — some homeowners refinance a mortgage to put student loans or other debts into one payment.
• You could change from an adjustable-rate to a fixed-rate mortgage.
• You might be able to cancel private mortgage insurance premiums to avoid paying unnecessary fees.

Cons

• You’ll have to pay closing costs.
• You might have a longer loan term, adding to your costs and delaying your payoff date.
• You could have less equity in your home if you take cash out.
• You might need to deal with borrower’s remorse if rates drop substantially after you close.
• It’s not an overnight activity: The refinancing process can take between 15 and 45 days or more.
• Your credit score will temporarily take a hit.
• Most refinances won’t affect your property taxes, but completing a remodel with a cash-out refinance can increase your home’s value — which could mean a higher tax bill.
• If you’ve paid off a significant chunk of your mortgage, refinancing might not make sense.

When to consider mortgage refinancing

Refinancing your mortgage is a significant financial decision, and knowing when to refinance is key. If you’re planning to remain in your home for years to come, extending your loan term to lower monthly payments — or using the equity you’ve built to finance home improvements — can make sound financial sense.

“The general rule of thumb is that you need to cut at least a full percentage point from your rate for refinancing to make sense. But the decision varies depending on your situation,” says Jeff Ostrowski, principal writer at Bankrate. “Maybe you have an FHA loan and refinancing would let you get out of mortgage insurance — that savings could nudge you toward a refi. Or perhaps you live in a state that taxes refinances — that could push the costs to a point that it doesn’t make sense.”

Knowing when to consider a refinance also depends on the general financial climate. If refinancing will mean getting a significantly higher interest rate on your mortgage, you should strongly consider not refinancing. However, refinance rates are beginning to ease from their post pandemic highs, which could encourage some homeowners to refinance.

“For the small group of homeowners who took loans at 8 percent in 2023, now is a great time to refinance,” says Ostrowski. “For most homeowners, though, the moment has yet to arrive.”

Mortgage refinance FAQ

• What does it cost to refinance a mortgage?
  

  Closing costs on a mortgage refinance can run between 2 and 5 percent of the amount you refinance. These line items include discount points, your loan’s origination fee and an appraisal fee to evaluate your home’s worth. You’ll need to calculate the break-even point of all these expenses to see if you’ll stay in your home long enough to recoup them and benefit from the refinance savings.

• Does refinancing affect my credit?
  

  Refinancing a mortgage can impact your credit, but it’s usually minimal. This can occur for multiple reasons. Mortgage lenders conduct a credit check to see if you qualify for a refinance, which appears on your credit report. A single inquiry can shave up to five points off your score. If you plan to apply for other types of debt, such as a car loan or credit card, your credit score can also be affected.

  When you refinance, you’re closing one loan and opening another. Your credit history makes up 15 percent of your score, so closing one loan and opening another has an impact.

  In general, these effects will only be felt for a short time. If you’re concerned about hurting your score while comparing refinance offers, try to shop for loans within a 45-day window. Any credit pulls related to your refinance in this timeframe will only be counted as one inquiry.

• Can I tap into home equity without refinancing?
  

  You can access equity in your home without refinancing your mortgage. Consider a home equity loan or a home equity line of credit (HELOC) as alternative ways of reaching your financial goals.

• What is the difference between loan modification and refinancing?
  

  A loan modification changes the rate or term (or both) of the existing mortgage loan. A mortgage refinance changes the rate or term (or both) through a new mortgage loan.

• Is a second mortgage the same as refinancing?
  

  A second mortgage and a refinance are not the same thing. A refinance replaces your current mortgage with a new one, and you’ll only have one payment at one interest rate. A second mortgage involves taking out equity you’ve built up in your home and using it elsewhere, such as with a home equity loan. A second mortgage adds another monthly payment you’ll need to budget for.

• Can you reduce your monthly payment without refinancing?
  

  You can reduce your monthly mortgage payment by recasting your mortgage. With a mortgage recast, you’ll make a lump sum payment toward the principal balance of your mortgage. Your lender will then reamortize your loan, taking into account the new principal balance and lowering your monthly payment.

• How soon after closing can I refinance?
  

  The time you have to let your mortgage season before refinancing depends on the loan type and the mortgage investor. FHA loans require you to wait six months, for example. Besides time, another limiting factor when refinancing a mortgage is equity. In general, you’ll need at least 20 percent equity before refinancing.