How does refinancing a mortgage work?

After you’ve had your mortgage for a few years, you might start wondering if you can get different terms, or even get some cash out of your home.

Refinancing your mortgage is a way to get a new home loan. This new loan pays off your old mortgage and can potentially provide you with a lower monthly payment, lower interest rate or some other benefits, including cash.

Before you decide to refinance, though, it’s important to consider your situation and your options. Here’s what you need to know about refinancing a mortgage.

What does it mean to refinance?

When you refinance a mortgage, you use a new loan to pay off the old loan. For example, let’s say you borrowed $250,000 to buy a home. Over the last few years, you’ve paid down the balance so that you have $225,000 remaining. When you refinance, you get a new loan. That money is used to pay off the old loan.

Your new loan has different terms. You usually end up with a new interest rate, and you have a new loan term. For example, if you have 20 years left on your mortgage, you can decide to get a 30-year loan or refinance to a shorter term. What you decide when you refinance impacts how long you will be paying on the home, as well as your interest rate and monthly payment.

How does mortgage refinancing work?

Mortgage refinancing works by replacing your old loan with a new one. As a result, you’ll likely need to go through steps similar to what you did when you bought your home to begin with. When you refinance, you should be prepared for the following steps.

Application

You need to apply for a mortgage refinance. The lender will check for proof of income and pull your credit history. You’ll probably need to provide pay stubs and tax returns, and consent to them looking at your credit score.

Interest rate

Decide whether you want to lock in an interest rate at the beginning of the process. Many people choose to refinance because they’re hoping for a lower interest rate. However, a mortgage refinance can take up to 30 days—or longer—to complete and rates might change. Decide whether you want to risk rates rising. You can also ask for a “float-down” rate, which protects you if rates rise, but also lets you take advantage of falling rates.

Appraisal

The lender will require that your home go through the appraisal process. They want to be sure your home is still valuable enough to cover the new loan. Additionally, if you’re getting a cash-out refinance, the lender needs to know the home has enough equity to cover the cash.

Fees and closing costs

You might have fees and closing costs with your mortgage refinance. If you plan to refinance in an effort to save money in the long run, make sure you understand whether you’ll be able to offset the costs with your savings.

Once everything is cleared and you’re approved, you can move forward with the refinance. The amount you get for the new loan will be used to pay off your original mortgage and you’ll have a new payment.

Types of mortgage refinance

As you consider refinancing, it’s important to understand the type of loan you’re looking for. Here are some of the options when it comes to mortgage refinancing.

Rate and term refinance

This type of refinance is aimed at changing your interest rate and your repayment term. In many cases, borrowers use this type of loan to save money in the long run.

For example, if you refinance to a lower interest rate and longer payment term, you might be able to save money on interest while at the same time getting a lower monthly payment. You have more money in your pocket each month, while saving overall.

Another type of rate and term refinance is aimed at paying off the loan earlier and saving even more. For example, you might decide to refinance the 20 years remaining on your loan to a 15-year mortgage. Your payments might be higher, even with a lower interest rate, but you’ll be out of debt faster and save even more in interest.

Carefully run the numbers and consider your goal in refinancing. You want to make sure that your new rate and term matches your objectives and will help you better reach your financial goals.

Cash-out refinance

With a cash-out refinance, you attempt to take advantage of the equity in your home and get a chunk of cash. For example, let’s say you have $225,000 remaining on your mortgage. The market value of your home is $350,000. You decide to refinance your home for $260,000. The difference between the new loan amount and what you owe comes to you in the form of cash. In this case, you would get $35,000 in cash, minus any fees you decided to pay upfront. Many lenders will only let you get a new loan up to 80% of the home’s value, so consider that when looking into a cash-out refinance.

A twist on the cash-out refinance is the cash-in refinance. In this case, you actually put money into the home and refinance a lower amount. This can help you reduce your interest rate and monthly payment, while also shortening the term and potentially saving you money. A cash-in refinance can be an option if you have outside capital and want to pay off your mortgage faster.

Reverse mortgage

A reverse mortgage is actually a type of mortgage refinance. Qualified borrowers (usually those who have reached a specific age) with sufficient equity built up can get a mortgage that allows them to receive payments or a lump sum.

This type of refinance is a little different, though, because you don’t make regular payments. Instead, once you move out of the home and sell it, the proceeds are used to pay off the loan. If you want to pass your home down to your heirs, a reverse mortgage might not be a good idea. Additionally, it’s important to double-check fees and other costs, since they can be relatively high.

Other types of mortgage refinance

There are other options with a mortgage refinance, such as one with no closing costs, or a short refinance.

It’s important to pay attention to the costs and fees, as well as other terms, when it comes to refinancing. With a no closing cost refinance, chances are there are still closing costs—you just don’t pay them upfront. You might cover those costs by having them rolled into your mortgage balance or by paying a higher interest rate.

A short refinance can work for someone in danger of foreclosure, if the original lender agrees. In this case, your balance is adjusted to something lower with monthly payments that you can afford. Depending on the situation, this arrangement can potentially result in a lower credit score.

Carefully consider your options and needs before deciding what type of mortgage refinance to get.

Refinance a mortgage pros and cons

Pros

• Potential to save money each month or on interest overall.
• Might be able to get a more manageable payment and reach other goals.
• A cash-out refinance can potentially provide needed capital for other objectives.

Cons

• It can take days or weeks to get approved and go through the process.
• Closing costs and other fees can offset some of the savings associated with refinancing.
• You could reduce the equity in your home, especially with a cash-out refinance.

When should you refinance your mortgage?

Refinancing your mortgage might make sense when you have a clear goal in mind and getting a new mortgage with new terms is likely to help you reach that goal. Carefully consider what you hope to accomplish with the refinance and determine whether the cost and effort are worth it.

For example, you might have a variable rate on your mortgage and be worried that interest rates will rise. Refinancing to a fixed rate can help you lock in current rates before they rise. Plus, you now have predictability in your payment.

Another potential reason to refinance is to pay off high-interest debt. If you have enough equity in your home, a cash-out refinance could help you pay off the credit cards and save money on interest overall. However, you need to weigh the risks. Once you use the money from the refinance to pay off your credit cards, you could end up back in debt. If an emergency arises and you can’t make your new payments, you could also lose your home.

Consider whether refinancing will help you reach your goals, and weigh the risks involved before you move forward.

Frequently asked questions (FAQs)

What does it cost to refinance your mortgage?

It depends on the lender and the fees they charge. Depending on the situation, you might reasonably expect to pay somewhere between 2% and 6% of the amount you’re refinancing.

Is a second mortgage the same thing as refinancing?

No. In general, a second mortgage refers to a home equity loan or line of credit. It’s a second loan on the same property. Refinancing pays off your original mortgage, replacing it with different terms. Refinancing can be used to help pay off a second mortgage as well as the first mortgage.

Does refinancing affect my credit score?

Refinancing can potentially affect your credit score. The credit check required might impact your credit. Additionally, refinancing registers as a new loan. As long as you make regular payments, though, your credit score could potentially rise in the future, after refinancing.

What happens to your money when you refinance?

If you do a cash-in refinance, the money goes to reduce your overall principal. It results in a lower loan amount. With a cash-out refinance, you receive the proceeds and you can generally choose what to do with the money.

Do you get money back after refinancing?

In general, unless you do a cash-out refinance, you won’t receive money back at the end of the transaction. You only get money back if you have enough equity in your home and you choose a cash-out refinance.