How Does Refinancing Work? A Guide for Homeowners

You can refinance your mortgage for a variety of reasons. A lot of homeowners refinance because rates are constantly changing, home improvement projects are on the horizon and saving money is always a good feeling.

What is refinancing?

Refinancing is when you pay off an existing loan with a new loan. Mortgage refinancing may allow you to borrow funds at a more favorable interest rate, repay the funds over a different length of time, and withdraw from or add to your home equity, depending on the type of mortgage refinance product.

How does refinancing work?

When you refinance, you acquire a new mortgage loan which is used to pay off the original loan. Your new monthly payments, length of loan and interest rate are all based on the terms of the new refinanced loan. For example, if you refinance to a 30-year mortgage, it doesn't matter how many years you paid on your original loan — your payment cycle with the new loan will start over and continue for 30 years. Or if you owed $400 each month for private mortgage insurance (PMI) premiums on your initial loan, but your loan refinance does not include PMI, for example, because you have reached 20% equity in your home, then amounts you had previously paid every month toward PMI would not be included.

Why refinance a mortgage?

Depending on your financial circumstances or current interest rates, there are several ways refinancing could be beneficial to you. Some of the common reasons to refinance:

• Reduce monthly payment
• Reduce total interest paid
• Shorten the length of the loan
• Change rate type (for example, from adjustable rate to fixed rate)
• Draw cash out to pay for other expenses or debts
• Cancel mortgage insurance premiums

Timing your refinance

The ideal time to refinance is based on your own circumstances. A good time to refinance is typically when you can qualify for a low enough interest rate to save money over the life of your loan, even after the cost of refinancing. Generally, if you can reduce your interest rate by a half of one percent or more, then the savings could be worth it. You just need to keep your home long enough to realize the savings. 

For example, if you have a $280,000 mortgage with a 7% interest rate you could save $132 a month over the life of the loan by refinancing the same amount into a 6% interest rate; this calculation does not include the cost of refinancing which can vary.

Another potentially good time to refinance is when you’ve amassed enough equity to drop PMI, saving you cash each month. Between the lower interest rate on the loan and the elimination of PMI, it’s possible you could save hundreds each month. It’s important to keep in mind that refinancing comes with its own costs, so if you’re planning to move in the near future, it might not be worth it for you. To get an idea of how the math might pencil out for your specific circumstances, try this Refinance Calculator.

Types of refinance mortgage loans

Homeowners can choose from a few different refinance products depending on their financial goals: rate-and-term refinance, cash-out refinance, cash-in refinance and streamline refinance. And as long as you meet the lender’s qualification requirements, almost any loan can be refinanced. 

Rate-and-term refinance

A rate-and-term refinance allows you to take out a new loan with a different interest rate and term, but for the same total loan amount.

Reasons for a rate-and-term refinance

• Reduce your monthly payments
• Save on overall interest
• Pay off your loan faster (if you elect a shorter loan term than what remains on your existing loan)
• Switch from adjustable-rate to fixed-rate program

Cash-out refinance

A cash-out refinance allows you to withdraw cash from the total equity in your home by increasing the loan amount for your new loan. Monthly payments typically increase with a cash-out refinance.  

Reasons for a cash-out refinance

• Free up equity for home improvements or other uses
• Pay off higher-interest debt with equity

Cash-in refinance

A cash-in refinance allows you to pay a lump sum toward home equity, reducing the remaining loan amount. Cash-in refinances often entail borrowers contributing tens of thousands of dollars to lower the amount they will borrow under the new loan. 

Reasons for a cash-in refinance

• If the balance on your mortgage is higher than the market value of your home
• Potential to cancel your PMI (private mortgage insurance)
• Reduce your monthly payments
• Qualify for a reduced interest rate

Streamline refinance 

A streamline refinance allows you to improve your mortgage interest rate with a new loan of the same type — without the hassle of the standard qualification process. This is not a cash-out option and it is not available to everyone. Keep in mind, lenders have their own processes, so there will be some qualification steps.

A streamline refinance is a special refinance program for people who have government-backed Federal Housing Administration (FHA) or VA loans. It’s the simplest and easiest way to refinance an FHA loan since it allows a borrower to refinance without having to verify their income and assets.

An appraisal might not be required either depending on how much you have paid on your original loan balance. Even if your home is worth less than the amount you owe, you still may be able to refinancing with a streamline refinance.

Reasons for a streamline refinance

• Reduce your interest rate
• Save money over the life of your loan

How much does it cost to refinance?

Typical mortgage refinance closing costs can range from 2% to 6% of the loan’s principal. On a $250,000 loan, for example, refinance closing costs might be $5,000-$15,000. If you elect to roll these costs into your new refinanced loan, this can increase your new monthly payments.

How to refinance a mortgage

The process of refinancing a mortgage follows these six steps:

1. Prepare for refinancing
2. Calculate a target refinance interest rate
3. Shop and apply for refinance loans
4. Lock your refinance interest rate
5. Complete a home appraisal
6. Pay and close

1. Prepare for refinancing

Lenders each have their own qualifying criteria, but generally you can expect a deep dive into your financial circumstances. This includes the pulling of your credit report and a review of your existing debt, payment history, current income and property value. 

Credit: Check your credit score because it will affect the interest rate provided by lenders.

Employment: Lenders want to review your employment history, along with current pay stubs and verification of your position. 

Home equity: Check your home equity balance. To save on PMI, the amount of your refinance loan will need to be less than 80% of the value of your home.

Home condition: Lenders may require an appraisal to assess your home's value, which helps them determine how much money they're willing to loan you. Homes in peak condition are appraised higher than homes in poor condition, so it helps to wrap up incomplete home improvements. Depending on how much you plan to borrow, the appraisal may also affect the interest rate offered to you.

2. Calculate a target refinance interest rate

To lower the principal and interest portion of your monthly payment, you'll need to find an interest rate you can qualify for that is lower than the interest rate on your existing loan. 

Refinance rates are often higher than mortgage rates for a home purchase in part because lenders may see them as higher risk loans. This makes it especially important to talk to a lender and shop around to make sure you’re getting the best possible rate and loan type to fit your financial goals.

When you refinance, it’s likely the loan will be amortized, which means that the costs of borrowing are spread over time according to a set schedule. Early payments are heavily weighted with interest on the loan, with only a small share of those payments going toward paying down the principal or loan balance. Over time, a higher share of the payment goes toward paying down the principal. If you’ve had your existing mortgage for a long time before refinancing, be aware that you’ll be paying mostly interest again in the early years of the loan.

Research current mortgage rates: If you're watching rate trends, you'll know when rates are low enough to pursue an advantageous refinance loan. 

Use a mortgage refinance calculator: To determine your total savings, you will need to know your current loan amount, loan interest rate, term and origination year.

3. Shop and apply for refinance loans

You can contact multiple lenders and inquire about rates, fees and lender qualification criteria. If you inquire with a lender about a mortgage and provide specific pieces of information such as requested loan amount, property address, and your income, a  lender will provide you with a Loan Estimate, which includes an estimated interest rate, monthly payment and closing costs and fees for a specific mortgage loan. You can compare the Loan Estimate from multiple lenders to compare the costs associated with taking out a loan and make an informed decision that works best for you.

Common fees for refinancing a mortgage:

• Origination fees
• Lending fees
• Escrow and title fees
• Credit fees
• Insurance fees
• Property taxes
• Appraisal fees
• Interest rate discount fees

Request all quotes in a similar time frame: Hard inquiries into your credit within a similar time period may be  considered one inquiry and generally should drop your credit score only a couple of points. Multiple inquiries over a longer time period can damage your credit.

Compile common application documents: 

• Pay stubs for the past two to three months
• Tax returns for the past two years
• Bank statements for the past two months
• A list of assets
• A list of liabilities

4. Lock your refinance interest rate

Once you’ve chosen your lender, you'll have the opportunity to lock your interest rate. Locking the rate means the lender will agree to provide a specific interest rate if you close your loan during a preset period of time. This is typically 30-60 days but can sometimes extend up to 120 days. 

During that time, the lender will work on completing the remaining steps to review your application for a refinance. If rates increase during your lock period, your rate will not increase. If rates decrease during the time period, you may have the opportunity to 'float down' the locked rate to the currently offered lower rate. This typically costs a fee and is a one-time option.

5. Complete a home appraisal

The lender will likely require a home appraisal to determine the value of the house. Appraisals are completed by a third-party, certified home appraiser and cost about $300 to $500 for a single-family home in the suburbs but might run $650 or more in urban markets. 

What happens during a home appraisal for refinance?

The appraiser will come to your home and analyze and photograph the exterior and interior condition. Appraisers focus on the number of rooms, bathrooms, recent updates, layout functionality and home systems like plumbing and HVAC. Appraisers also consider the presence of safety features like fire and carbon monoxide alarms. They'll compare the location and witnessed conditions to similar nearby homes that have recently sold. 

6. Pay and close

At closing, you'll pay closing costs and sign your new loan documents. Your lender will wire funds to pay off your previous mortgage. The title and escrow agent will facilitate the signing of the refinance paperwork, in general it can take an hour or two to complete.

The bottom line  

Volatile mortgage rates can make it hard to determine whether and when to refinance. By keeping your eye on rates and staying connected to your loan officer, you’ll be better able to gauge what’s best for you.

Interested in refinancing? Find a lender on Zillow who can help.