Mortgage Refinancing: What Is It And How Does It Work?
Victoria Araj6-minute read
September 16, 2021
Your home is an investment. Refinancing is one way you can use your home to leverage that investment. There are several reasons you may want to refinance, including getting cash from your home, lowering your payment and shortening your loan term.
Let’s look at how refinancing a mortgage works so you know what to expect.
What Does It Mean To Refinance A House?
When you refinance the mortgage on your house, you’re essentially trading in your current mortgage for a newer one, often with a new principal and a different interest rate. Your lender then uses the newer mortgage to pay off the old one, so you’re left with just one loan and one monthly payment.
There are a few reasons people refinance their homes. You can use a cash-out refinance to make use of your home’s equity or a rate-and-term refinance to get a better interest rate.
A refinance could also be used to remove another person from the mortgage, which often happens in the case of divorce. Finally, you can add someone to the mortgage.
How Does Refinancing A Home Work?
The refinancing process is often less complicated than the home buying process, although it includes many of the same steps. It can be hard to predict how long your refinance will take, but the typical timeline is 30 – 45 days.
Let's take a closer look at the refinancing process.
When you apply to refinance, your lender asks for the same information you gave them when you bought the home. They’ll look at your income, assets, debt and credit score to determine whether you meet the requirements to refinance and can pay back the loan.
Some of the documents your lender might need include your:
- Two most recent pay stubs
- Two most recent W-2s
- Two most recent bank statements
Your lender will also need your spouse’s documents if you’re married. You might be asked for more income documentation if you’re self-employed. It’s also a good idea to have your tax returns for the last couple of years handy.
You don’t have to refinance with your current lender. If you choose a different lender, that new lender pays off your current loan, ending your relationship with your old lender. Don’t be afraid to shop around and compare each lender’s current rates, availability and client satisfaction scores.
Locking In Your Interest Rate
After you get approved, you may be given the option to lock your interest rate so it doesn’t change before the loan closes.
Rate locks last anywhere from 15 – 60 days. The rate lock period depends on a few factors like your location, loan type and lender. If your loan doesn’t close before the lock period ends, you may be required to extend the rate lock, which may cost money.
You might also be given the option to float your rate, which means not locking it before proceeding with the loan. This may allow you to get a lower rate, but it also puts you at risk for getting a higher one. In some cases, you might be able to get the best of both worlds with a float-down option, but if you’re happy with rates at the time you’re applying, then it’s generally a good idea to go ahead and lock your rate.
Once you submit your application, your lender begins the underwriting process. During underwriting, your mortgage lender verifies your financial information and makes sure that everything you’ve submitted is accurate.
Your lender will verify the details of the property, like when you bought your home. This includes an appraisal to determine the home’s value. The refinance appraisal is a crucial part of the process because it determines what options are available to you.
If you’re refinancing to take cash out, for example, then the value of your home determines how much cash you can get. If you’re trying to lower your mortgage payment, then the value could impact whether you have enough home equity to get rid of private mortgage insurance or be eligible for a certain loan option.
Just like when you bought your home, you must get an appraisal before you refinance. Your lender orders the appraisal, the appraiser visits your property and you receive an estimate of your home’s value.
To prepare for the appraisal, you’ll want to make sure your home looks its best. Tidy up and complete any minor repairs to leave a good impression. It’s also a good idea to put together a list of upgrades you’ve made to the home since you’ve owned it.
If the home’s value is equal to or higher than the loan amount you want to refinance, it means that the underwriting is complete. Your lender will contact you with details of your closing.
What happens if your estimate comes back low? You can choose to decrease the amount of money you want to get through the refinance or you can cancel your application. Alternatively, you can do what’s called a cash-in refinance and bring cash to the table in order to get the terms under your current deal.
Closing On Your New Loan
Once underwriting and home appraisal are complete, it’s time to close your loan. A few days before closing, your lender will send you a document called a Closing Disclosure. That’s where you’ll see all the final numbers for your loan.
The closing for a refinance is faster than the closing for a home purchase. The closing is attended by the people on the loan and title, and a representative from the lender or title company.
At closing, you’ll go over the details of the loan and sign your loan documents. This is when you’ll pay any closing costs that aren’t rolled into your loan. If your lender owes you money (for example, if you’re doing a cash-out refinance), you’ll receive the funds after closing.
Once you've closed on your loan, you have a few days before you're locked in. If something happens and you need to get out of your refinance, you can exercise your right of rescission to cancel any time before the 3-day grace period ends.
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4 Reasons To Refinance Your Mortgage
As we mentioned, there are a variety of reasons why you might want to refinance your mortgage. Let’s look at some of the main reasons here.
1. Change Your Loan Term
Many people refinance to shorten their loan term to save on interest. For example, say you started with a 30-year loan but can now afford a higher mortgage payment. You might refinance to a 15-year term to get a better interest rate and pay less interest overall.
You can also lengthen your loan term to lower your monthly payment.
2. Lower Your Interest Rate
Interest rates are always changing. If rates are better now than when you got your loan, refinancing might make sense for you. Lowering your interest rate can lower your monthly payment and you’ll pay less interest over the life of your loan.
3. Change Your Loan Type
There are many reasons a different type of loan may benefit you. Perhaps you originally got an adjustable-rate mortgage (ARM) to save on interest, but you’d like to refinance your ARM to a fixed-rate mortgage while rates are low.
Maybe you finally have enough home equity to refinance your FHA loan to a conventional loan without paying for private mortgage insurance.
4. Cash Out Your Equity
With a cash-out refinance, you borrow more than you owe on your home and pocket the difference as cash. If your home’s value has increased, you may have enough equity to take cash out for home improvement, debt consolidation or other expenses. Using cash from your home allows you to borrow money at a much lower interest rate than other loan types.
What Does It Cost to Refinance?
The total cost of a refinance depends on a number of factors like your lender and your home’s value. Expect to pay 2 – 6% of the total value of your loan.
The nice thing about refinancing is that you may not have to pay those costs out of pocket. In some cases, you can get a no-closing-cost refinance so you don’t have to bring any money to the table. Be aware that closing cost is then paid for over the life of the loan in the form of a higher rate.
When Should You Refinance Your Mortgage?
There are a lot of factors to think through when deciding if you should refinance or not. Consider market trends (including current interest rates), as well as your personal financial health (especially your credit score). It’s a good idea to use a mortgage refinance calculator to calculate your break-even point after accounting for refinancing expenses.
You also need to know how refinancing differs from other mortgage options like loan modification and second mortgages. The major difference between a refinance and a loan modification is that refinancing gives you a new mortgage while modification changes your current terms. The new mortgage you get from refinancing replaces the existing one, an important distinction between getting a second mortgage and refinancing. Review what works best for you before deciding what to do.
It’s important to note that a modification should only be considered if you can’t qualify for a refinance and you need long-term payment relief. Modification typically has a major negative impact on your credit score.
The Bottom Line: Refinancing Can Make Your Home Work For You
When the time is right, refinancing is a great way to use your home as a financial tool. You can adjust your loan term, get a better interest rate and change your loan type to save money in the long term. Or cash out your home's equity and use the money as you need it.
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