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What is mortgage refinancing and how does it work?

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While it’s not the best time to refinance due to rising interest rates, you might still consider refinancing if you want to tap your home’s equity. If you’re considering refinancing, here’s how it works and what options might be available to you.

What is refinancing?

When you refinance your mortgage, you replace your current mortgage with a new loan. The new loan might have different terms — moving from a 30-year to a 15-year term or an adjustable rate to a fixed rate, for example — but the most common change is a lower interest rate. Refinancing can allow you to lower your monthly payment, save money on interest over the life of your loan, pay your mortgage off sooner and draw from your home’s equity if you need cash for any purpose.

How does refinancing a mortgage work?

Similar to when you first applied for your mortgage, a lender will review your finances to assess your level of risk and determine your eligibility for the most favorable interest rate. It’s an entirely new loan, and it could be with a different lender than the one you originally worked with to buy your home.

Your new loan might also 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. If you refinance to a new 30-year loan, you’ll start over and have 30 years again to repay it. If you refinance to a new 20-year loan instead, you’ll pay your loan off five years earlier.

Refinancing comes with closing costs, which can affect whether getting a new mortgage makes financial sense for you. These costs can be between 2 percent and 5 percent of the amount you refinance. Common closing costs include discount points, an origination fee and an appraisal fee. You’ll need to calculate the break-even point to determine whether you’ll stay in your home long enough to recoup the closing costs and benefit from the savings of the refinance.

Types of mortgage refinancing

Rate-and-term refinance

This is a basic form of refinancing that changes either the interest rate of the loan, the term (repayment length) of the loan or both. This can reduce your monthly payment or help you save money on interest. The amount you owe generally won’t change unless you roll some closing costs into the new loan.

Cash-out refinance

When you do a cash-out refinance, you’re using your home to take cash out to spend. This increases your mortgage debt but gives you money that you can invest or use to fund a goal, like a home improvement project. You can also secure a new term and interest rate during a cash-out refinance.

Cash-in refinance

With a cash-in refinance, you make a lump sum payment in order to reduce your loan-to-value (LTV) ratio, which cuts your overall debt burden, potentially lowers your monthly payment and also could help you qualify for a lower interest rate. Before making a cash-in refinance, you’ll want to evaluate whether paying the lump sum would deprive you of more lucrative opportunities or needlessly drain your savings.

No-closing-cost refinance

A no-closing-cost refinance allows you to refinance without paying closing costs upfront; instead, you roll those expenses into the loan, which will mean a higher monthly payment and likely a higher interest rate. A no-closing-cost refinance makes most sense if you plan to stay in the home short-term.

Short refinance

If you’re struggling to make your mortgage payments and are at risk of foreclosure, your lender might offer you a new loan lower than the original amount borrowed and forgive the difference. While a short refinance spares the borrower the financial impacts of a foreclosure, this option comes at the expense of a hit to your credit score.

Reverse mortgage

If you’re a homeowner aged 62 or older, you might be eligible for a reverse mortgage that allows you to withdraw your home’s equity and receive monthly payments from your lender. You can use these funds as retirement income, to pay medical bills or for any other goal. You won’t need to repay the lender until you leave the home, and while the income is tax-free, it’ll accrue interest.

Debt consolidation refinance

Similar to cash-out refinances, debt consolidation refinances give you cash with one key difference: You use the cash from the equity you’ve built in your home to repay other non-mortgage debt, like credit card debt. Your mortgage debt will increase, but because mortgage rates are usually lower than those for other forms of debt, this can save you money in the long run. Plus, you might be able to take advantage of the mortgage interest deduction.

Streamline refinance

A streamline refinance accelerates the process for borrowers by eliminating some of the requirements of a typical refinance, such as a credit check or appraisal. This option is available for FHA, VA, USDA and Fannie Mae and Freddie Mac loans.

How to refinance a mortgage

If you’re thinking about refinancing a mortgage, here’s a step-by-step guide on the process. Before you refinance, it’s important to understand how long it will take for the costs of refinancing to pay off compared to how long you plan to stay in the home. You’ll also want to ensure you can afford the new payment and you’ll have enough equity remaining in your home. To get a good deal, shop around between mortgage lenders.

Consider the interest rates as well as closing costs.

Common reasons to refinance

Refinancing requires some work, so is it really worth the extra paperwork and additional costs? There are some great reasons to invest the time and money in a refinance:

  • You can get a lower interest rate. — The biggest reason to refinance is the opportunity to lower your interest rate. Whether your credit has dramatically improved since you first secured your mortgage or the market has changed, access to a lower interest rate can save you loads of money over the course of the loan. That said, in today’s rate environment, you’re unlikely to save significantly unless you got your original mortgage at least 10 years ago.
  • You can get a different kind of loan. — Maybe you want to replace the uncertainty of an adjustable-rate mortgage with a fixed-rate mortgage, or maybe you’re hoping to stop paying FHA mortgage insurance by switching to a conventional loan. Refinancing gives you the chance to explore all the types of home loans to find an option that works better for your finances.
  • You can use your equity to borrow more money. — In addition to saving money, refinancing might be able to help you access more funds. Cash-out refinancing allows you to leverage the equity you’ve accumulated to borrow a bigger sum of money. While this adds to your debt, it can help you secure funding for big expenses — a home improvement project or college education, for example — at a relatively low interest rate.
  • You can shorten your loan. — If you currently have 20 years left on a 30-year mortgage, for instance, you might want to refinance into a 15-year loan for a long-term savings opportunity. Your monthly payments could go up, but you’ll pay off your home faster.

Pros and cons of refinancing a mortgage

If you’re thinking about refinancing, make a list of the advantages and disadvantages to see if it’s right for you.

Pros

  • You could lower your interest rate.
  • You could lower your mortgage payment and create more space in your monthly budget.
  • You could decrease the term of your loan and pay it off sooner.
  • You could tap into your home’s equity and take cash out at closing.
  • You could consolidate debt — some homeowners use refinancing to put student loans or other debts into one simple payment.
  • You could change from an adjustable-rate to a fixed-rate mortgage, or vice versa.
  • You might be able to cancel private mortgage insurance premiums to avoid paying unnecessary fees.

Cons

  • You’ll have to pay closing costs.
  • You might have a longer loan term, adding to your costs and delaying your payoff date.
  • You could have less equity in your home if you take cash out.
  • You might need to deal with borrower’s remorse if rates drop substantially after you close.
  • It’s not an overnight activity: The refinancing process can take between 15 and 45 days or more.
  • Your credit score will temporarily take a hit.

Does refinancing affect my credit?

Refinancing a mortgage can have some impact on your credit, but it’s usually minimal. This can occur for multiple reasons:

  • Mortgage lenders conduct a credit check to see if you qualify for a refinance, and this appears on your credit report. A single inquiry can shave up to five points off your score.
  • If you plan to apply for other types of debt, such as a car loan or credit card, in addition to refinancing, your credit score can also be affected.
  • When you refinance, you’re closing one loan and opening another. Your credit history makes up 15 percent of your score, so having one loan close and then taking on a new one shortens the duration, impacting your score.

In general, these effects will only be felt for a short period of time. If you’re concerned about hurting your score while you compare refinance offers, try to shop for loans within a 45-day window. Any credit pulls related to your refinance in this timeframe will only be counted as one inquiry.

Bottom line

Refinancing can be one of the best financial decisions you make. If you’re planning to continue living in your home for a long time, lowering your interest rate by more than half a percentage point can make a huge difference in your budget. Learn more about when’s a good time to refinance your mortgage.

With additional reporting by David McMillin and TJ Porter

Written by
Erik J. Martin
Contributing writer
Erik J. Martin is a Chicago area-based freelance writer/editor whose articles have been featured in AARP The Magazine, Reader's Digest, The Costco Connection, The Motley Fool and other publications. He often writes on topics related to real estate, business, technology, health care, insurance and entertainment.
Edited by
Mortgage editor
Reviewed by
Senior wealth manager, LourdMurray
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