Mortgage Refinancing 101

When you have a mortgage, you’re locked into monthly payments at a certain interest rate for a set period of time. The only way you can change that rate or repayment period is by refinancing. If interest rates go down, you can refinance your mortgage to save money on your monthly payments. But a refinance mortgage isn’t always cheaper in the long run — even if you manage to get a lower mortgage rate. We’ll help you answer a critical question: “Should I refinance my mortgage?” and show you how to refinance a home so you save money.

What Is A Mortgage Refinance?

When you refinance a mortgage, you basically replace your existing mortgage with a new one. You can switch banks and change the terms of your mortgage, and although you’re technically applying for a new loan, refinances usually require less paperwork and close faster than a “purchase” mortgage.

You may want to refinance in order to:

  • secure a lower mortgage rate
  • lower your monthly payments
  • change to a fixed-rate or variable-rate loan
  • change lenders
  • change the length of your mortgage
  • cash out some of your home’s equity for other bills

There are 3 types of refinances: cash-out, cash-in and rate-and-term. Refinance mortgage rates are different for each, so here’s a closer look at each refinance mortgage type.

Cash-out refinance

Cash-out refinances are useful when you need to tap into your home’s equity to finance something else. Perhaps you’d like to remodel the kitchen and need a lump sum of money, or you’d like to pay off high-interest debt like credit cards. You can borrow money for these needs against the value of your home by refinancing. The drawback of a cash-out mortgage is the increase in the amount you’re borrowing. If you time things right, you can get a lower interest rate that could offset the higher loan amount, making your monthly payments about the same. Banks consider cash-out mortgages riskier and may require a higher credit score to qualify, or limit the cash-out amount to $250,000.

Cash-in refinance

A cash-in refinance it the opposite of a cash-out refinance, where a homeowner pays a lump sum towards their mortgage balance owed to the bank. A cash-in refinance may result in a shorter term, lower refinance mortgage rates or both. The most common reason for a cash-in refi is to get rid of the mandatory monthly private mortgage insurance (PMI) payments required because you paid less than a 20% down payment when you purchased the home. PMI will cost 0.5% to 1.0% of the loan amount, which can add up to hundreds of dollars per month. Pay down your mortgage to an 80% loan-to-value (LTV) ratio and you’ll save yourself the insurance cost.

Rate-and-term refinance

Rate-and-term refinances are popular because they allow you to change the interest rate and/or loan term. When interest rates fall, most refinances are rate-and-term refinances. A homeowner can refinance from a 30-year fixed-rate mortgage to a 15-year fixed-rate mortgage, or lock in a lower interest rate. You can also cash out some of your equity, but usually not for more than $2,000. Closing costs in this type of mortgage can be added to the loan balance, so you save yourself from having to pay the costs out-of-pocket.

Should I Refinance My Mortgage?

Refinancing when interest rates are low seems like a no-brainer — but there’s more to think about than just a cheaper interest rate. Let’s consider some scenarios. Refinancing from a 30-year loan to a 15-year loan sounds like a good idea. You’ll pay your house off faster and be free and clear in half the time. But refinancing to a 15-year mortgage usually results in a dramatically higher monthly payment. Even with a lower interest rate, you’re looking at a much bigger monthly payment. Will this strain your household budget?

If you want to pay your loan off sooner, leave your term at 30 years and make extra payments. One extra mortgage payment per year can shave four years or more off your loan term, just make sure you designate all of the extra payment toward the principal of the loan.

The biggest catch when it comes to a refinance mortgage is the closing cost. Closing costs are the fees a mortgage lender collects when you refinance. They usually run between three and six percent of your loan’s principal. A $300,000 refinance can cost you between $9,000 and $18,000 in fees.

When asking yourself, “Should I refinance my mortgage?” the key is to figure out if refinancing will save you more than you’re going to pay in closing costs. To figure it out:

  • Determine how much you’ll save each month from the lower interest rate.
  • Calculate what your closing costs will be.
  • Divide the closing costs by the monthly savings to see how long it will take to recover the costs.

For example, if you’re thinking of refinancing a $200,000 mortgage from five percent to 4.25 percent, it will cost you $8,000 in closing fees. Your old monthly payment was $1,074 and your new one is $984. You’re saving $90 per month. Now divide the $8,000 in fees by your $90 per month savings. It will take you about 89 months to recover your closing costs. If you plan on living in your home longer than seven and a half years, you’ll save money. If not, you won’t.

How to Refinance a Home

  1. Determine if refinancing is cheaper in the long run.
  2. Monitor your home’s value using websites like Zillow and to find out what current sales prices are like and what similar neighborhood properties have recently sold for. You’ll need to make sure you have at least 20% equity in your home to cash out. If you’re looking to drop the interest rate or change the length of the loan, you’ll need between five and 10 percent home equity.
  3. Check your credit score, since most lenders require good credit to refinance.
  4. Organize your paperwork. You’ll probably need recent bank statements, two years of tax forms, and pay stubs.
  5. Get ready for an appraisal by making sure your home is clean and decluttered, your lawn is mowed and your garden is attractive.
  6. Shop around for the best refinance mortgage rates. You don’t have to stick with the same lender, so explore your options. Don’t forget to compare closing costs and fees, too.
  7. Apply for a refinance with at least three lenders for the best rate. If you do so within a couple of weeks, your credit score should be minimally affected. Experian says, “Multiple loan inquiries for the same type of loan in a short window of time (ranging between 14 to 45 days) are typically treated as a single inquiry by most credit scoring models.”
  8. Choose the best lender by reviewing and comparing their loan estimate documents, a detailed report showing you closing costs, interest rates and loan terms.
  9. Lock your interest rate in. When you choose a lender and lock in your interest rate, it can’t be changed for a set amount of time so your lender has time to close the loan before the rate expires.
  10. Close on the loan by meeting at a notary office or somewhere similar to sign documents and pay the closing costs.

Unlike a regular mortgage, no keys are exchanged once the paperwork is complete. You’ll start making payments to your new lender as agreed and your new terms or rates will apply.