You may have thought that once you purchased your home and took out a 30-year mortgage, you’d never have to apply for a mortgage again. After a few years, however, you may decide that it makes sense to refinance your home loan. Here’s what you need to know:
What is mortgage refinancing?
Refinancing a mortgage means you get a new home loan to replace your existing one. If you can refinance into a loan that has a lower interest rate than you’re currently paying, you may be able to save money. The best time to consider doing a refinance is when interest rates fall sharply, and sink well below the level they were at when you closed on your original mortgage. Another good opportunity is when your credit improves to the point where a new loan has a lower interest rate.
As a rule of thumb, it’s worth considering a refinance if you can lower your interest rate by at least half a percentage point, and you’re planning to stay in your home for at least a few years. You can find and shop refinance lenders in your area here.
Why you should consider refinancing
There are a variety of reasons that might make financial sense to refinance your home loan:
- To reduce your monthly mortgage payment by securing a lower interest rate
- To get a shorter term, such as a 15-year loan to replace a 30-year mortgage, so you can pay it off faster and pay a lot less in total interest
- To switch from an adjustable-rate mortgage to a fixed-rate loan — a smart move if you think rates are going to go up in the future
- To extract cash from your home’s equity in what’s known as a cash-out refinance
- To eliminate mortgage insurance if you’ve built up 20 percent equity in your home
How to refinance your mortgage
The process of refinancing is similar to getting a mortgage when you purchase your home.
Step 1: Set a clear financial goal.
There should be a good reason why you’re refinancing, whether it’s to reduce your monthly payment, shorten the term of your loan, or pull out equity for home repairs or debt repayment.
“Every situation is unique,” says Ann Thompson, Bank of America’s head of retail sales West. “Everyone has different priorities.”
What to consider: If you’re reducing your interest rate but restarting the clock on a 30-year mortgage, you may end up paying less every month, but more over the life of your loan. That’s because the bulk of your interest charges are in the early years of a mortgage.
Step 2: Check your credit score and history.
You’ll need to qualify for a refinance, just as you needed to get approval for your original home loan. The higher your credit score, the better refinance rates lenders will offer you–and the better your chances of underwriters approving your loan.
What to consider: It may make sense to spend a few months boosting your credit score before you start the refinancing process.
Step 3: Determine how much home equity you have.
Your home equity is the value of your home in excess of what you owe the bank on your mortgage. To figure it out, check your mortgage statement to see your current balance. Then check online home search sites or get a real estate agent to run an analysis to find the current estimated value of your home. Your home equity is the difference between the two. For example, if you still owe $250,000 on your home, and it is worth $325,000, your home equity is $75,000.
What to consider: You may be able to refinance a conventional loan with as little as 5 percent equity, but you’ll get better rates and fewer fees if you have more than 20 percent equity. The more equity you have in your home, the less risky the loan is to the bank or lender.
Step 4: Shop multiple lenders.
Getting quotes from multiple lenders can save you thousands of dollars. Once you’ve chosen a lender, discuss when it’s best to lock in your rate and not having to worry about rates climbing before your loan closes.
What to consider: In addition to comparing interest rates, pay attention to the cost of fees and whether they’ll be due upfront or rolled into your new mortgage. Lenders sometimes offer “no-closing cost loans” but charge a higher interest rate or add to the loan balance.
Step 5: Be transparent about your finances.
Gather recent pay stubs, federal tax returns, bank statements, and anything else your lender requests. Your lender will also look at your credit and net worth, so disclose your assets and liabilities upfront.
What to consider: Having your documentation ready before starting the refinancing process can make it go more smoothly.
Step 6: Prepare for the appraisal.
Some lenders may require an appraisal to determine the home’s current market value for a refinance approval.
What to consider: You’ll pay a few hundred dollars for the appraisal. Letting the lender know of any improvements or repairs you’ve made since purchasing your home could lead to a higher appraisal.
Step 7: Come to the closing with cash, if needed.
The closing disclosure, as well as the loan estimate, will list how much money you need to pay out of pocket to close the mortgage.
What to consider: You might be able to finance those costs, which typically amount to a few thousand dollars, but you’ll likely pay more for it through a higher rate or loan amount.
Step 8: Keep tabs on your loan.
Store copies of your closing paperwork in a safe location and set up autopayments to make sure you stay current on your mortgage. Many lenders will also give you a lower rate if you sign up for autopayment.
What to consider: Your lender might resell your loan on the secondary market either immediately after closing or years later. That means you’ll owe mortgage payments to a different company, so keep an eye out for mail notifying you of any such changes.
Benefits of refinancing your mortgage
- Free up money each month. A rate-and-term refinance replaces your mortgage with a new loan that has a lower rate, meaning you have to pay less to your lender each month. “There’s a significant opportunity to reduce your monthly cash requirements,” says Glenn Brunker, a mortgage executive with Ally Home. “Depending on the size of your mortgage, it could be $75 or $100 per month, or even several hundred dollars a month.”
- Pay your home off more quickly. You may be able to refinance into a loan with a lower interest rate and a shorter term. The savings in interest payments could be substantial, for example, if you’re able to refinance into a 15-year mortgage from a 30-year loan. Still, if you’re putting more cash into paying off your mortgage, you may have less money on-hand for expenses like saving for retirement, college or an emergency fund.
- Eliminate private mortgage insurance. If your original down payment was less than 20 percent, you have likely been paying private mortgage insurance, or PMI, an extra fee on every payment. If rising home values and your loan payments have pushed your home equity above 20 percent, you might be able to refinance into a new loan without PMI.
- Tap your home’s equity. Homeowners with at least 20 percent equity in their home sometimes turn to cash-out refinancing. That’s when you refinance your home loan into a new mortgage for a larger amount, to meet a specific financial need and receive the difference in cash. This may make sense if you’re considering using the money to invest back into your home through a major remodeling project or to pay off high-interest debt.
- Lock in a fixed-rate mortgage. If you’re in an adjustable-rate mortgage that’s about to reset and you believe that interest rates are going to rise, you can refinance into a fixed-rate loan. Your new rate might be higher than what you’re paying now, but you’re guaranteed that it won’t rise in the future.
Risks and costs of refinancing your mortgage
While refinancing can be a smart move, it’s not right for everyone. Refinancing can be a mistake if you aren’t able to lower your interest rate by much or you incur a lot of fees. Here’s what to keep in mind:
- Refinancing isn’t free. Your refinanced mortgage comes with costs, such as origination fees, an appraisal, title insurance, taxes and other fees, just like your original mortgage. Even if the refi results in a lower monthly payment, you won’t actually save money until the monthly savings offset the cost of refinancing. You’ll need to do some math (use this calculator) to figure out how many months it will take to reach this break-even point. If there’s a chance you’re going to move before then, refinancing is probably not the best move.
- You may have a prepayment penalty. Some lenders charge you extra for paying off your loan amount early. A high prepayment penalty could tip the balance in favor of sticking with your original mortgage.
- Your total financing costs can increase. If you refinance to a new 30-year mortgage, you’re likely going to pay significantly more interest and fees over the life of your loan than if you’d kept the original mortgage.
No cash-out refinance vs. cash-out refinance: What’s the difference?
When you refinance in order to reset your interest rate or term, or to switch, say, from an ARM to a fixed-rate mortgage, that’s called a no cash-out refinancing, or a rate-and-term refinancing. Rate-and-term refinancing pays off one loan with the proceeds from the new loan, using the same property as collateral. This type of loan allows you to take advantage of lower interest rates or shorten the term of your mortgage to build equity more quickly.
By contrast, cash-out refinancing leaves you with more cash than you need to pay off your existing mortgage, closing costs, points and any mortgage liens. You can use the cash for any purpose. To be eligible for cash-out refinancing, you typically need to have at least 20 percent equity in your home.
Example of a no cash-out refi (or a rate-and-term refi):
Jessica gets a $100,000 mortgage with an interest rate of 5.5 percent. Three years later, interest rates have fallen and Jessica can refinance with an interest rate of 4 percent. After 36 on-time payments, she still owes about $95,700.
In this situation, Jessica can save more than $100 per month by refinancing and starting over with a 30-year loan. Or she can save $85 per month, while keeping the loan’s original payoff date, paying it off in 27 years, and also reducing the total cost of the loan by about $8,000. Better still in terms of saving on interest would be to refi into a 15-year loan. The monthly payments will be higher but the interest savings is massive.
Example of cash-out refinancing:
In this case, Christopher and Andre owe $120,000 on a mortgage on a home that’s worth $200,000. That means that they have 40 percent, or $80,000, in equity. With a cash-out refinance, they could refinance for more than the $120,000 they owe. For example, they could refinance for $150,000. With that, they could pay off the $120,000 on the current loan and have $30,000 cash to pay for home improvement and other expenses. That would leave them with $50,000, or 25 percent equity.
Next steps: How to get the best refinance rate
Once you’ve determined why you want to refinance and the type of loan you want, you’re ready to shop lenders and compare refinance rates. Get quotes from at least three lenders, including a mortgage broker, a bank and an online lender. Be sure to compare both their rates as well as fees and other charges that could add to the overall cost of the loan.
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