How Does Refinancing Work?

How & When to Refinance, Mortgage Refinancing, Mortgages

Are you stuck with a mortgage that no longer works for you? Maybe your interest rate is too high, or you’re struggling to make your monthly mortgage payments. Maybe interest rates are falling or your credit score is rising, and you want a better deal. 

No matter the reason, refinancing your mortgage could be the solution that unlocks new financial potential.

Refinancing can help make your mortgage more affordable, potentially saving you thousands of dollars in the process. But how does refinancing work? 

We’ve put together a comprehensive overview so you can determine whether refinancing is the right move for you.

What Does Refinancing Mean? 

When homeowners refinance, they replace their existing mortgage with a new one. A lender pays off the original home loan and issues a new mortgage with a new interest rate and terms.

The goal of refinancing is to lower your interest rate, reduce your monthly mortgage payments or shorten your loan term – all goals that can save you money over time.

But how soon you can refinance after securing a mortgage depends on the type of mortgage you have.

Check Your Credit Score

If your credit score has increased since you took out your original loan, refinancing could provide access to better terms or lower rates.

What Are the Reasons To Refinance a Mortgage? 

Refinancing your mortgage can be beneficial if you want to switch lenders, shorten the loan term, pay off your mortgage faster or reduce your monthly mortgage payments.

If your credit score has improved since you took out your original loan or interest rates have dropped, refinancing can help you take advantage of these changes.

Homeowners also refinance their mortgages to tap into home equity or switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage.

Secure a better interest rate

In the real estate market, interest rates can fluctuate – and that can be to your benefit.

Getting a lower interest rate will translate into paying less interest over the life of your mortgage. If you have a 30-year mortgage with an 8% interest rate, refinancing to a 6% interest rate can save you thousands – unless what you pay in closing costs to refinance reduces or cancels out your savings.

Lower interest rates also translate to lower monthly mortgage payments – freeing up more cash for other expenses or money goals and more financial freedom.

Leveraging home equity

Your home equity is the difference between the amount you owe on your mortgage and the fair market value of your home.

As you make your monthly mortgage payments and the value of your home increases, your equity grows. Refinancing allows you to tap into the wealth growing in your home.

From home improvements to removing mortgage insurance, you can use the equity in your home for everything from home improvements to debt consolidation to paying off medical bills

Shorten the mortgage term

Most home buyers go for the most popular loan term: the 30-year mortgage.

A 30-year mortgage may appear to have a lot of advantages – and it does – but in the long run, you end up paying more in interest because you’re taking 30 years to pay off your loan, and that’s a long time.

By refinancing to a 15-year mortgage or a 10-year mortgage, you can pay off your loan faster and save on interest.

For example, you’d pay twice as much for a 30-year mortgage with an 8% interest rate than a 15-year mortgage at the same rate. Considering the higher total cost, many homeowners refinance and switch to a shorter-term loan.

Because your monthly mortgage payments will be higher with a shorter-term loan, this option is best for homeowners with higher or increased incomes that can comfortably afford larger monthly payments.

Shortening your mortgage term allows you to build equity and own your home faster, and you’ll pay less interest in the long run.

Get a different type of loan

You can refinance to switch from your existing loan to another loan that may offer better terms.

Let’s say you have an FHA loan and want to stop paying the mortgage insurance premium (MIP). If you refinance with at least 20% equity in your home, you can switch to a conventional mortgage and remove the mortgage insurance.

Refinancing can also help you switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage.

How To Refinance 

Whether you’re looking to lower your monthly payments or cash out home equity, refinancing is a great option – when done correctly. Here are the steps you’ll need to follow:

1. Assess your situation

Sometimes, the desire to refinance is a no-brainer: You want to pay off your loan faster or lower your monthly payments. But before you can start the process, it’s essential to evaluate your financial goals and decide what makes the most sense for you.

The first step should be to review your finances and credit history to see if you meet the requirements of the loan you want. Depending on the type of mortgage refinance, lenders typically require a credit score of 620 or higher and a debt-to-income (DTI) ratio of 43% or less.[1]

For government-backed loans, like the Federal Housing Administration (FHA) Streamline Refinance and Department of Veterans Affairs (VA) Streamline Refinance (or VA IRRRL), you can qualify with a lower credit score.

2. Apply for refinancing 

Now it’s time to start looking at lenders.

You can use your current lender to refinance, but we recommend you shop around and compare potential lenders to find the best rates.

Once you’ve decided on a lender, you’ll need to submit an application. Your lender will review your application and assess your credit history and finances to verify that you qualify for the loan.

3. Lock in a new interest rate

The next step is to lock in your new interest rate. A rate lock freezes the mortgage rate and protects you in case market interest rates go up.

Many homeowners consider this an essential step. The slightest bump in interest can significantly affect your total loan amount.

Keep in mind that your new interest rate will depend on the type of loan you’re taking out and other factors like your credit score, debt-to-income (DTI) ratio and the equity in your home. 

4. Complete the underwriting process

The mortgage underwriting process is the last step before closing, and it involves a thorough review of your finances.

The underwriter will review every aspect of your finances, including a hard pull on your credit report, calculating your DTI ratio and confirming your available funds for closing costs.

The underwriter will also verify your employment status using bank statements, tax and other financial documents. 

You will likely need a home appraisal to ensure your property is worth the loan amount you want to take out.

By the way, if this sounds familiar, it should. It’s a lot like the process you went through when you applied for your original mortgage.

Mortgage refinance underwriting usually takes about 30 – 45 days. Depending on your lender, it can take more or less time.

To help streamline the underwriting process, you need to be as organized and proactive as possible. Make sure all your financial documents are up-to-date and ready for review. If your lender has questions, answer them ASAP and stay in communication with them throughout the underwriting process.

If you meet all your lender’s criteria, you’ll likely be approved, and the lender will move to close.

5. Close on your refinanced mortgage

When the underwriter approves your application, the lender will send over a Closing Disclosure for you to review. This document outlines the details of the loan, including closing costs.

Generally speaking, closing costs on a mortgage refinance will be similar to the closing costs you paid on your original mortgage. Your costs may include fees for loan origination, the appraisal, the title search and pulling your credit report.

Before you sign the closing documents, check that all the information is correct and compare its details with your Loan Estimate. If everything looks good, go ahead and sign on the dotted line.

What Are the Different Types of Mortgage Refinancing? 

There are many types of mortgage refinancing available – each with its advantages and disadvantages.

The best option for you will depend on your goals, needs and financial situation. Some of the most popular refinancing options include:

  • A rate and term refinance: Borrowers can change a loan’s interest rate and term without taking out extra cash. It is the most common type of refinancing.
  • A cash-out refinance: With a cash-out refinance, you take out a new and larger mortgage loan that pays off and replaces your existing mortgage. The money left over is yours to keep and use for any purpose.
  • An FHA Streamline Refinance: FHA Streamline Refinance loans help homeowners with FHA mortgages get a new loan with a lower rate and lower monthly payments. It’s easier to qualify for than conventional refinancing and requires less documentation.
  • A VA Streamline Refinance: Veterans and active-duty service members with VA loans can apply for a VA Streamline Refinance (or VA IRRRL). They can refinance to a lower rate without providing documentation.

How much does it cost to refinance?

Typically, you’ll pay between 2% and 5% of the total loan amount in closing costs and other fees. But the cost to refinance will vary depending on the type of loan and other factors. Typical costs include application fees, title search fees, appraisal fees, title insurance and closing costs.

Will refinancing impact your credit score?

Yes, refinancing will impact your credit score. When you apply for a refinance loan, the lender performs a “hard pull” on your credit report. The pull (or hard inquiry) will cause your credit score to drop slightly and will stay on your report for 2 years.

What could disqualify you from refinancing? 

Anything that might cause you to default would disqualify you from refinancing, including bad credit, high debt-to-income (DTI) ratio, low income, insufficient equity and other financial concerns.

How much equity do you need to refinance? 

The amount of equity you need to refinance will depend on the loan type and the lender. Generally, lenders prefer homeowners to have 15% – 20% equity in their homes.

Can you get cash from refinancing? 

Yes, you can get cash from refinancing. It’s called a cash-out refinance. It involves taking out a new mortgage loan with a larger balance than your existing loan. The money left over between the two loans is yours to keep and use for any purpose.

A More Manageable Mortgage

Homeowners can take advantage of refinancing to reduce their costs or shorten the length of their loans. It can be a great way to make your mortgage more manageable. 

With a more manageable mortgage, you can focus on other money goals like paying off high-interest debt, retirement savings or making much-needed improvements to your home. Consider all your mortgage refinancing options before you decide whether you should refinance – and what works best for you.

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