How does mortgage refinancing work?

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Mortgage rates hit an all-time low recently. That has prompted a flurry of homeowners to refinance. Others may be waiting things out or need to know more before proceeding. They may be asking themselves: How does refinancing work? And how will it benefit me?

The refinancing process isn’t much different from what was involved when you first bought your home and closed on a mortgage, but there are specific items you need to look at closely. Understanding how refinancing works and the options available to you can put you in a better position to make a more informed decision and get the best rate.

What’s involved in the mortgage refinancing process

When you refinance, you take out a new mortgage loan to pay off your old mortgage loan. The new loan will have a different interest rate, terms and conditions than the old loan. You may also have a different lender.

With a new loan, you may reset the repayment clock. Say you’ve made five years of payments on your current 30-year mortgage. That means you have 25 years left on the loan. But if you refinance to a new 30-year mortgage loan, you’ll start over and have 30 years to repay. Or, if you refinance to a new 20-year mortgage loan instead, you’ll pay that loan off five years earlier than expected.

“Refinancing shouldn’t affect one’s credit,” says Matt Hackett, operations manager at Equity Now, a direct mortgage lender in New York City. “When you apply for a mortgage refinance, it triggers a hard credit inquiry that may lower your credit score by only a few points, but this will be temporary.”

Common reasons to refinance a mortgage

Alan Rosenbaum, CEO and founder of New York City-based GuardHill Financial Corp., says there are many good reasons to pursue a refinance.

“You may be able to reduce your interest rate and monthly mortgage payments,” says Rosenbaum. “Also, if you’ve built up equity in your home, you can take out cash at closing to pay for home improvements, consolidate debt, invest, or pay for a large transaction.”

You can also refinance to shorten your term and pay off the loan faster, resulting in less interest paid over the life of your loan. One option is refinancing a 30-year mortgage into a 15-year loan.

If you have an adjustable-rate mortgage, switching to a fixed-rate loan can be a smart move, too; you’ll have the peace of mind of knowing that your principal and interest payments due each month will stay the same.

And if you’ve been paying private mortgage insurance, refinancing can allow you to eliminate those payments if you’ve accrued at least 20 percent equity in your home.

“The best candidates for refinancing are homeowners who have a high interest rate on their current loan, have a strong equity position, or have a need for cash to fund other family expenses or plans,” says Guy Silas, branch manager at Embrace Home Loans, headquartered in Middletown, Rhode Island.

If you can reduce your mortgage rate by one-half to three-quarters of a percentage point or more, refinancing is probably worth it as long as you plan to stay in the house long enough to recoup the considerable costs involved. Our mortgage refi calculator can help you decide.

The pros and cons of refinancing

In summary, the benefits to refinancing include the ability to:

  • Lower your interest rate
  • Lower your mortgage payment
  • Decrease the term of your loan and pay it off sooner
  • Tap into your home’s equity and take cash out at closing
  • Consolidate debt
  • Change from an adjustable-rate to a fixed-rate mortgage or vice versa
  • Cancel mortgage insurance premiums

But refinancing has some drawbacks. These include:

  • Expensive closing costs–such as lender fees, appraisal fees, and possibly points—that often equate to 3 to 6 percent of the amount you’re refinancing
  • Possibly a longer loan term: If you’re resetting to a full 30 years, you’re adding extra years to your repayment calendar. That likely means paying more in total interest over the life of your loan.
  • Less equity in your home if you take cash out.
  • Borrower’s remorse: If rates drop substantially after you close and you want to take advantage, you may have to go through the entire refi process again.
  • Patience is required: The refinance process can take between 15 and 45 days, on average.

Due to the closing expenses involved, experts suggest not selling your home for at least three to five years after refinancing so that you can recoup these costs.

Types of refinancing options available

There are several types of refinancing options to choose from.

“The first is a traditional rate-and-term refinance that changes the rate, term or both,” says Silas. “The second is a cash-out refinance in which you take out equity from your property in the form of cash at closing.”

Another option is a debt consolidation refinance in which you pull out equity (cash out at closing) to pay off outstanding non-mortgage debt.

“There are also streamline refinance options, offered by the FHA, VA, Fannie Mae and Freddie Mac, that can speed up the refinance process for eligible borrowers,” Silas adds.

How to refinance

The steps involved in refinancing are similar to when you first sought a mortgage loan. You’ll need to:

  • Shop around for lenders online or at a brick-and-mortar bank, credit union or lending company
  • Compare rate quotes, terms and conditions carefully
  • Apply for a mortgage refinance loan and supply the necessary documents, including pay stubs, tax returns, bank statements, and lists of assets and liabilities
  • Lock in your interest rate
  • Provide an assigned lending professional anything else they request, including paying for an appraisal to determine your home’s market value
  • Close on the loan and pay associated closing costs

Learn more