How to Refinance a Home Loan
Be sure it makes sense for your situation
When interest rates fall, homeowners rush to refinance mortgages, often without pausing to consider whether it makes financial sense. Therefore, it’s important to understand what a refinance entails beyond just interest rates.
What Is Refinancing?
Refinancing is the process of taking out a new loan to pay off your original or refinanced mortgage and, in some cases, a home equity loan.
There is more than one type of mortgage, and it is possible to refinance with a different type of mortgage than the original loan. For example, having a fixed-rate mortgage doesn't mean that your lender requires you to refinance with a fixed-rate loan. Other refinancing options include FHA, interest-only, and adjustable-rate.
How to Refinance
Refinancing your mortgage is very similar to getting a mortgage for the first time. The main difference is that you don't have to find a home; you've already got one.
Get Multiple Quotes
Most refinance lenders will allow you to get a quote without affecting your credit score. You'll give them preliminary info about your debt and income. They'll give you corresponding quotes that include the rate, loan amount, repayment length, and monthly payment.
Be as accurate as possible when you provide preliminary information to your lender. Inflating your income and/or minimizing your debt can have a significant impact on your rates.
Narrow Down Your Offers
Once you receive your quotes, you'll need to choose the offers you think are best. Then, you’ll fill out a more extensive application for the offers you select. The process includes a more in-depth analysis of your debt and income. You'll likely need to provide your social security number for a credit check, as well as your income and how much you want to borrow. Based on this information, the lender can provide you with a loan estimate that details the loan's rate, amount, repayment term, and fees.
Choose Your Lender and Close the Loan
With your offers now in hand, you can pick one lender with which you want to refinance your mortgage. Notify them you want to proceed. From there, the lender may ask you for bank statements, pay stubs, W-2’s, tax returns, and more. If your application is approved, you should receive a series of disclosures from the lender detailing your loan terms, fees, and APR.
Then, your lender will likely order an appraisal just like they'd do for a purchase mortgage. Once you clear the application process and appraisal, you and the lender will close on your refinance.
According to mortgage company Freddie Mac, the average refinance process takes between 30 and 45 days.
Costs to Refinance
Refinancing a mortgage is not as simple as changing to a lower interest rate or otherwise different terms. It involves taking out an entirely new loan, and that means fees. If your mortgage lender is not making money by charging upfront costs, the lender usually rolls the fees into the loan or you pay a higher-than-market interest rate to make up for it.
Watch out for the following common fees:
- Loan origination
- Credit report
- Title-related fees
After you review the fees your lender charges, ask the lender if the fees are negotiable. In some cases, you can lower them or the lender might eliminate certain fees.
Keep an eye out for a “yield spread premium” (YSP). A YSP is fee the lender to the mortgage broker for bringing your loan. Often, loans that don’t have an origination fee include a YSP.
Benefits of Refinancing
The red tape of applying for a new loan can be a hassle and the fees can be expensive. However, refinancing a mortgage can still be a good option. Some of the most common benefits include:
Lower monthly payments
If you plan to stay in a home long enough to break even on the refinance costs, a lower interest rate leads to lower payments that can free up cash for your monthly budget. Some homeowners use that extra cash to invest, while others may save it.
Option to shorten the repayment period
If your interest is substantially lower than your previous rate, you might want to consider shortening the term of your loan in exchange for a higher mortgage payment. Depending on your financial plan and age, it might benefit you to pay off your mortgage early.
Avoid an ARM Rate Increase
Some borrowers have an adjustable-rate mortgage (ARM). In most cases, these mortgages have a fixed rate for a certain time (five years, for example). After that time, the rate varies depending on the market.
If you're looking at a big rate increase, refinancing to a fixed-rate mortgage can help you avoid that rate bump. But be warned: Your monthly payments could go up.
Use Your Home's Equity
Often, lenders have an option for a "cash-out refinance." With this loan, the lender will approve you for more money than what’s remaining on your existing mortgage based on the equity (home value minus what you owe) in your home. You can then cash-out that difference and, for example, use the money to renovate your kitchen and further boost your home’s value.
The potential for savings is great, but it's not always reality when it comes to refinancing. Before assuming that refinancing at a lower interest rate is a good idea, do your own math to be sure. Some reasons to skip refinancing include:
It costs money to get the loan, which you might not recoup through a lower interest rate for a number of years. To figure this out, add up all the fees. Figure out the difference between your old mortgage payment and your new payment. Divide your loan fees by that difference. The result is equal to the number of months you must pay on your new loan to break even. If your loan fees are $4,000, for example, and the monthly savings will be $100 per month, it will take you 40 months to break even on the refinance.
Longer repayment period
Borrowers generally extend the term of the loan after they refinance. Say you have a 30-year mortgage and, after 10 years, you refinance to a 25-year mortgage. The 10 years of payments plus another 25 years equals 35 years of payment instead of the original 30.
By rolling the costs of your refinance into the loan itself, you are taking out a bigger mortgage, which eats away at the equity you have in your home. Moreover, if you do a cash-out refinance, your loan balance will increase.
The Bottom Line
Refinancing can be an excellent way to lower your interest rate. If rates have dropped significantly since you bought your home, you may be able to save yourself hundreds of dollars per month or shorten your repayment period. Smart consumers will review their refinance offer to identify the fees involved, then ask to negotiate those fees. Once you’ve got a final offer from your lender, calculate how long it will take you to break even on your refinance. Also, consider the total number of years it will take to repay the refinance.
If you believe the break-even timeline is too long, or that you aren’t comfortable with the extra years a refinance adds to your total repayment period, a refinance might not be right for you.
However, if you’ll break even quickly or you believe the extra money you free up each month outweighs your fees and extended repayment, a refinance could be a great fit.