Refinancing a mortgage involves replacing an existing loan with a new one. Refinancing swaps out your current mortgage for one that ideally offers better terms. Homeowners typically refinance a mortgage to secure more favorable interest rates or other loan features that can save them money.
Some homeowners refinance to take their equity in cash to pay for some planned or unforeseen expense.
Definition and Example of Refinancing
Refinancing is the process of paying off your existing mortgage and creating a new one. It allows you to replace an unsatisfactory or unsustainable home loan with one you can live with over the long term. The process can result in lower monthly payments and other terms that will make your payments more manageable, but it can also leave you worse off financially under certain circumstances.
Refinancing follows a similar process to obtaining your original mortgage, since you may encounter many of the same procedures, and the same types of costs, the second time around.
Compare the benefits of refinancing against the drawbacks, then run the math on the savings and costs. This will help you determine whether it's the right approach and the right time for you.
How Refinancing Works
The steps you must take to refinance a mortgage are similar to those you took to get your current loan.
Determine the Loan Features You Want
It's important to establish the specific interest rate or term length you want in advance, whether your aim is to secure a lower rate, to switch to a fixed interest rate, or to extend your loan term.
You can use a loan amortization calculator to see how your payment would change with a different interest rate or loan term if you're not sure what loan features you need.
Settle on a Lender
You don't have to choose your current mortgage loan provider for a refinancing. Shop around for a qualified lender who offers the terms you're looking for. Get at least three or four loan quotes before you choose one. Don't be afraid to bargain on negotiable terms, such as interest rates, closing costs, and other fees.
Apply for a Loan
This process can vary slightly by lender, but they'll walk you through unique steps in their process, if any. Review the loan terms and fees in the contract when you're approved so that you know what to expect and you can avoid surprise costs.
You'll continue to make payments on the refinanced loan until you pay it off or refinance it again.
Reasons to Refinance a Mortgage
A restructured loan can improve your financial situation in several ways, and refinancing can be a logical choice if any of them meet your personal needs.
You'll generally achieve lower, more manageable monthly payments when you refinance your mortgage into a loan with a lower interest rate or a longer term.
You'll pay less in interest costs over the mortgage's lifetime, which reduces your total loan cost, if you refinance your loan with one with a lower interest rate.
The benefits of switching from an adjustable-rate mortgage (ARM) to a fixed-rate loan are two-fold. You can prevent the interest rate on the loan from increasing in the future and you can ensure predictable monthly payments.
You can receive a cash payment for the difference if you refinance with a loan that's more than the principal balance you owe on your existing mortgage. This is known as cash-out refinancing. You can use the cash for home improvements, for long-term financial goals like sending your child to college, or for anything else you like.
A cash-out refinancing reduces the equity, or ownership, in your home, which means that you won't pocket as much after you sell it.
The cash you receive from a cash-out refinancing can also be used to pay off other debts, such as high-interest credit cards. This can reduce the total number of debts you owe and make loan repayment more manageable.
When You Won't Want to Refinance
Refinancing can also have a negative financial impact if you don't carefully evaluate the terms of your restructured loan.
A better loan isn't guaranteed. You might not be approved for a loan with lower interest rates if your credit is lackluster at the time of application, or if market interest rates have increased since you took out your first mortgage.
Your total lifetime interest costs might increase if your new loan term is the same as your current mortgage. You would be paying 40 years of interest if you'd paid on your current 30-year mortgage for 10 years, then refinanced that mortgage for another 30 years.
The new loan amount will be more than you owed on the old one, resulting in higher monthly payments, if you do a cash-out refinance.
Should I Refinance?
In general, mortgage refinancing is a good move when you’ll truly benefit financially from a new loan. It can be a bad move if you'll waste money or increase risk when you refinance, so weigh the pros and cons of your old loan against a new loan to decide whether it's worth the cost.
One way to accomplish this is to do a basic break-even analysis. This will help you determine how much you’ll save over time and how long it will take you to recoup any upfront costs.
Some clues that a mortgage refinancing might be worthwhile include:
- Interest rates are low. Changes in market conditions might allow you to secure a lower interest rate when you refinance.
- Your credit has improved. Credit score increases can make you eligible for a loan with a lower interest rate.
- You plan to stay in the home for a long time. Refinancing a mortgage makes more sense if you plan to live in the home long enough to recoup the costs of restructuring the loan.
- You can avoid getting stung by a high-risk mortgage. Risky mortgage loans, such as an ARM with an APR that is much higher than the introductory rate, can cause your monthly payments to soar after the introductory period and increase the risk of default. Switching to a fixed-rate loan can minimize the risk in this case.
- Getting an amortizing loan versus an interest-only loan. A loan with payments that only cover interest during the initial period can result in payment shock after the interest-only period ends and payments go up dramatically. You can avoid this costly surprise if you refinance with an amortizing loan, which includes proportional interest and principal in the payments.
You might want to avoid refinancing your mortgage in some cases:
- Lifetime loan costs might be higher. Securing a lower monthly payment can save you money in the present, but it might cost you more in the long run.
- You plan to move in a few years. Your savings from the refinancing might not be enough to recoup the costs of refinancing if you move too soon after, making refinancing a losing financial proposition.
- Your existing mortgage includes a prepayment penalty. This is a fee charged by some lenders when you pay off a loan before the end of the loan term. It will add to your total loan costs if you can't get your initial lender to waive this penalty.
How Much Do I Pay to Refinance?
- Application fees: This expense covers the cost to process your loan and perform credit checks.
- Origination fees: This is a one-time fee that you pay for loan preparation.
- Appraisal fees: This covers the cost of an appraisal to assess the value of your home.
- Inspection fees: You'll be charged this fee if your home requires an inspection to assess its condition prior to being approved for a new mortgage.
- Closing costs: This includes fees for the attorney who handles the closing of the loan on behalf of the lender.
Altogether, refinancing fees can amount to 3% to 6% of the remaining principal on the mortgage. Your lender might not require that you pay these fees upfront if you qualify for a "no-cost refinancing," but you'll still effectively pay them through a higher interest rate over the course of the loan.
- Refinancing a mortgage is very similar to taking out any other mortgage. The primary difference is that the proceeds will pay off your existing mortgage rather than fund the purchase of a new home.
- It can be worth refinancing if you can lower your interest rate or otherwise favorably alter your loan terms to put you ahead financially.
- “Cash-out” refinances allow you to take your home equity in cash to pay for other wants or needs.
- Refinancing involves all the usual closing costs, so it might only be a worthwhile option if you plan to live in your home for a while.