Put simply, a mortgage refinance replaces one mortgage with another. People tend to avoid mortgage refinancing when rates are high, and average rates have been rising steadily since 2022, reaching a peak of 7.79% for a 30-year fixed-rate mortgage at the end of October 2023. However, they have dropped somewhat since then, standing at just 6.82% as of Apr. 4, 2024, leading some to think about refinancing.
Typically, people will refinance if interest rates have dropped below the rate they have on their mortgage. If conditions are right, a refinance can save you thousands of dollars over the life of your loan. It can also allow you to convert your home equity into cash.
Let’s examine exactly how mortgage refinancing works, the pros and cons of doing it, and the steps you need to take to accomplish it.
How does mortgage refinancing work
The process for refinancing a mortgage is similar to applying for a new mortgage. After you submit your application, your lender will perform a credit check, and you’ll have to provide financial documents. The lender may also require an appraisal of your home.
Pros and cons of refinancing mortgage
Pros:
- You may be able to secure a lower interest rate
- You may be able to reduce your amortization
- Access your home equity to pay for home renos or other major expenses
Cons:
- Setup costs can be expensive
- Refinancing may extend the time it takes to pay off your mortgage
- There may be penalties for breaking your current mortgage
Types of mortgage refinance
There are several different types of mortgage refinancing. Your best option will depend on your financial situation and goals.
Cash-in refinance
With a cash-in refinance you make a lump-sum payment on your mortgage, resulting in a lower principal balance. This is ideal for anyone looking to lower their loan-to-value, hoping to receive a lower interest rate, or wanting to remove private mortgage insurance.
Cash-out refinance
A cash-out refinance is used when you want to turn some of your home equity into cash. While this will increase the principal balance on your mortgage, you can use the cash to pay down debt or improve your home, among other things.
Streamline refinance
A streamline refinance requires less documentation and underwriting than a regular refinance. No appraisal is required, but you are limited to $500 in cash back. Streamline refinances can be done with loans from the Federal Housing Administration (FHA), U.S. Department of Agriculture (USDA), U.S. Department of Veterans Affairs (VA), Freddie Mac, and Fannie Mae.
Rate-and-term refinance
A rate-and-term refinance allows you to change the interest rate on your loan and/or its repayment terms.
Short refinance
If you are struggling to make your monthly mortgage payments or have defaulted, your lender might agree to do a short refinance in lieu of expensive foreclosure proceedings. This will give you a loan with a lower principal balance, leading to a lower monthly payment amount. The lender will then forgive the difference. Keep in mind that a short refinance could hurt your credit score.
Steps to refinance a mortgage
If you’re ready to refinance your mortgage, here are the steps you want to take.
1. Understand your reasoning for refinancing
Before you refinance, you need to understand your goals. Are you hoping to lower your interest rate? Do you want to access the equity you’ve built up so you can complete a home improvement project? Understanding your goals before starting will allow you to assess whether or not refinancing makes sense for your situation.
2. Check your credit score
To qualify for a mortgage refinance, your credit score must exceed the stated minimum. This will depend on the type of loan for which you’re applying. Here are some minimum credit score examples:
Your credit score will impact the interest rate you’re offered. If it isn’t as high as you’d like, spend a few months improving your score before refinancing.
3. Consider other lender requirements
Most lenders have other criteria for underwriting mortgage loans in addition to a minimum credit score. This includes a satisfactory debt-to-income ratio (DTI) and income. Here’s a closer look at each:
Debt-to-income ratio (DTI)
Your DTI ratio is the total amount you owe in monthly debts compared with your total income. The higher your DTI ratio, the riskier it will be for a lender to loan you money. While the exact number will vary based on the lender, a common benchmark to aim for is no higher than 45%. If you get it closer to 36%, then that could help you qualify for lower interest rates.
Income
Your lender will want to see that you have income to service the debt. To verify, it will request your most recent pay stubs. If you’re self-employed, you must submit 1099s or your tax returns from the past two years.
4. Check your home equity
Most lenders require at least 20% equity in your home before considering refinancing. The more equity you have, the lower the chance you will default on the loan.
To determine your home’s equity, determine how much you still owe on your mortgage. This information can be found on your monthly statement. Next, go to Zillow.com and get a good estimate of your home’s current value. You can also choose to have an appraisal completed, but it will cost money and may not be worth it, as your lender will likely require you to provide a separate appraisal before closing.
Once you know your mortgage balance and the current value of your home, you’ll have a better idea of whether you can move forward with refinancing.
5. Shop around for mortgage lenders
Once you’ve decided that refinancing your mortgage is the best option and your finances are in order, it’s time to start looking for a lender. Make sure you consider multiple options to find one with the best deal. Always put your current lender in the mix because it may be able to eliminate some of the refinancing fees for you.
When choosing a lender, consider the interest rate and closing costs, including whether the latter will be due up front out of pocket or rolled into your loan. Once you choose your lender, you’ll want to lock in the rate to avoid fluctuations.
6. Get your paperwork ready
Once you’ve applied for the loan, the lender will request your financial documents for underwriting. You’ll need your tax returns for the past couple of years, your W-2 or 1099s, bank and investment statements, and any documents related to student loan or credit card debts.
If you want to speed things up, you can gather all these documents before starting the refinancing process. Then, when the time is right, you can send everything off to the lender.
7. Prepare for the appraisal
Most mortgage lenders require an appraisal to determine your home’s current value. The appraiser will inspect your home and assess it based on a checklist of items. They will also consider recent comparable home sales in your neighborhood.
While the appraiser is in your home, mention any home improvement projects you’ve completed since you purchased the home. This could be a finished basement, a remodeled kitchen, or an extra bathroom. These things can help increase the value of your home in the eyes of the appraiser.
8. Closing your loan
Once you’ve been approved for the loan and the home appraisal meets the lender’s expectations, it’s time to close. On closing day, you will pay the closing costs to the lender. A breakdown of the fees can be found in either your loan estimate or the closing disclosure.
Nearly all lenders will allow you to pay the closing costs out of pocket. Some will offer a no-closing-cost refinance, allowing you to roll the closing costs into the loan amount. While this will reduce the amount you must pay on closing day, it usually means a higher interest rate. Talk to your lender to understand which will be best for you.
Where to refinance your mortgage
If you’re ready to start shopping for a new mortgage, here are a few lenders to consider.
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Best for lower credit scores |
15 to 30 years; 4.79% to 5.59% |
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15 to 30 years; 6.87% to 7.37% fixed |
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10 to 30 years; 6.27% to 8.15% |
*Rates as of April 9, 2024
What is the cost of refinancing a mortgage?
When you refinance your mortgage, you must pay closing costs to the lender. This is typically anywhere from 2% to 5% of the loan amount. For example, if your loan is $300,000 and closing costs are 2%, the total fee will be $6,000.
You’ll also want to check with your current lender to avoid surprise fees. Sometimes a lender will charge a prepayment fee if you pay off the balance before the loan term ends. This would be stated in your original loan documents.
When is a mortgage refinance worth it?
Refinancing a mortgage isn’t always the best financial move. Below are some times when it does make sense.
Reduce your monthly payment
Refinancing is a great choice if your goal is to reduce your monthly mortgage payment. If interest rates are lower today than when you first got your mortgage, your monthly payment will likely be less after a refinance.
Pay off your mortgage faster
If you started with a 30-year mortgage, you might decide you want to pay it off faster. In this case, it might make sense to refinance into a 10, 15, or 20-year mortgage.
Turn your home equity into cash
If you’d like to use your home equity to pay for home improvement projects or other debts, then a cash-out refinance is worth considering. If rates are lower when you refinance than when you initially received your mortgage, you may be able to tap into your equity and also lower your interest rate.
Eliminate private mortgage insurance
In general, lenders must automatically remove your private mortgage insurance once your loan balance reaches 78% of your home’s original value, and you can request its removal when it reaches 80%. A refinance can help you achieve this.
Switch from an adjustable-rate mortgage to a fixed-rate mortgage
Some people choose to have an adjustable-rate mortgage because they either don’t plan to stay in the home very long or want to take advantage of the lower interest rates offered. However, some people with adjustable-rate mortgages will look to refinance into a fixed-rate mortgage before the loan term expires.
TIME Stamp: Don’t refinance your mortgage without knowing what you want to achieve
There are many advantages to refinancing your mortgage. It can help you lower your monthly mortgage payment, pay off your mortgage faster, access the equity in your home, and remove private mortgage insurance. However, before making the decision to refinance, it’s important to weigh the costs involved to make sure it makes sense for your situation.
Frequently asked questions (FAQs)
How long does it take to refinance a mortgage?
The time it takes to refinance a mortgage varies from one lender to the next. However, on average, the process can take anywhere from 30 to 45 days.
Will refinancing affect my credit?
Because a lender will make a hard inquiry (or “pull”) on your credit, it will have a minor impact on your credit score. If you plan to shop with several lenders, try to complete the process within a 45-day window. This way, all credit inquiries related to your mortgage refinance will count as a single credit pull.
Is a second mortgage the same as refinancing?
No. They are two different things. When you refinance, you replace your original mortgage with a new one. This means you will still have just one monthly payment. A second mortgage would be a home equity loan, which would require a second monthly payment in addition to your mortgage payment.