Mortgage Refinancing: How It Works

Through a mortgage refinance, you can replace your original mortgage with a new one to get a better deal. The Mortgage Bankers Association reported in its weekly survey that mortgage refinance applications were 7% higher than the same time last year, attributing the rise to a dip in interest rates. Maybe you want more favorable terms, or perhaps you want to cash in some of the equity you’ve built up. You might be able to accomplish those financial goals through a mortgage refinance.

Refinancing a mortgage happens when you get rid of your current mortgage and replace it with a new one. You apply for a new mortgage to pay off the old one and begin paying off the new loan, typically with a different interest rate and payoff schedule. The process of applying for a refinance is similar to the steps you took when applying for your current mortgage. You’ll typically need to provide similar paperwork and pay closing costs.

You can refinance your mortgage with your current lender or you can use a different lender. Whichever you choose, the new loan pays off the old loan. 

Whether you use your current lender or a new lender to refinance your mortgage loan, you’ll need to apply for the refinance and be approved. Requirements vary by lender, but here is a list of some typical requirements you’ll need to refinance your loan:

• Current loan in good standing: You usually need to be current on your mortgage, with no missed payments and often with no late payments for a certain period, determined by the lender, prior to your application.
• A waiting period: Also called seasoning the loan, you typically need to have had your mortgage for at least six months before you can refinance, but this depends on the lender. Some lenders have no waiting period, while others want you to wait 12 months.
• Minimum credit score: Lenders set limits on what your credit score needs to be to refinance. Some lenders will steer clear of bad credit ratings, such as a FICO score ranging from 300 to 579. Keep in mind that the higher your credit score, the lower your annual percentage rate (APR) will likely be. 
• Steady income and employment: You’ll need to show proof of income and employment history.
• Sufficient home equity: You typically need at least 20% equity to refinance, but some lenders will let you refinance with less.
• Manageable debt load: Your debt-to-income ratio (DTI), which measures your monthly debt payments against your pre-tax monthly income, can’t be too high. The maximum DTI lenders will accept varies, and can be between 36% and 50%, according to Fannie Mae.

If you already have a mortgage, you might wonder why you’d want to refinance it. Here are five reasons:

If you can get a lower interest rate because interest rates have gone down or because you've raised your credit score, you should probably investigate refinancing your loan.

Loans can have a fixed rate or an adjustable rate. If your current mortgage has an adjustable rate, for example, and interest rates are starting to rise, you might want to refinance to a fixed-rate mortgage to avoid market fluctuations. 

If you have a 30-year loan, for example, and you want to pay it off sooner, you can refinance to a loan with a shorter term, such as 15 years. When you shorten the term, however, your monthly payment will likely be higher.

If you have equity in your home and want to use it, you can get a cash-out refinance by taking out a new mortgage for more than what you owe. Let’s say your home is currently worth $300,000, and you have a mortgage loan of $200,000. You could get a loan of up to $240,000, as most lenders will grant a refinance loan up to 80% of the home’s value. You could use the extra $40,000 for debt consolidation, home improvements, college tuition, or an investment property.

If you’re currently paying mortgage insurance that lasts the life of the loan with a Federal Housing Administration (FHA) mortgage loan, for example, and you have gained at least 20% equity in the home, you can refinance to a conventional loan to drop the mortgage insurance.

Before you refinance your mortgage, make sure you know what benefits you’re seeking. Whether you’re choosing a different loan term, aiming for a lower rate, or reducing your monthly payment, you’ll want to see benefits. Refinancing might be right for you, but there are a few considerations: 

A lower interest rate is an appealing reason to consider refinancing. It rarely makes sense to refinance to a higher interest rate. Freddie Mac predicted interest rates will dip later this year and will likely make refinancing a more attractive option for homeowners. 

You’ll need to crunch some numbers to determine whether you’ll save money in the long run by refinancing. With closing costs, you’ll either pay a lump sum in cash at closing or roll the cost of the refinance into the mortgage. Either way, a refinance might not be the best option unless the amount you save will be more than you pay in closing costs.

If you plan to move soon, you might not want to refinance. It’s best to stay in the home long enough to make the refinance cost and effort worthwhile. For example, if your goal is to lower your monthly payment, and it will cost you $7,000 to refinance to save $200 a month, you would need to stay in the home for more than 35 months to make the refinance worthwhile.

There are several types of mortgage refinance loans. Here are some popular options to consider:

• Rate-and-term refinance: Considered a traditional refinance, this product can result in more favorable terms, such as a lower interest rate or a shorter loan term.
• Cash-out refinance: This allows you to take cash out of the equity you’ve amassed from making your mortgage payments.
• Streamline refinance: This type of loan allows you to refinance an existing FHA mortgage loan with a new FHA mortgage loan.
• Reverse mortgage: This product allows homeowners to borrow against the equity in their home without making monthly payments. The loan is paid back when the borrower no longer lives in the home.
• No-closing-cost refinance: With this product, you either roll the closing costs into the loan amount or the lender pays your closing costs but charges you a higher interest rate.
• Short refinance: This is like a short sale in that your mortgage lender forgives some of your mortgage balance and provides you with a new loan. If you’re at risk of foreclosure, your lender might grant this.

Freddie Mac estimates it costs $5,000 to refinance a home loan, but this could vary based on the size of the loan — 2% to 5% of the loan is typical. You might be able to roll some of these costs into your loan, but it will increase the amount you pay over the life of the mortgage.

You should refinance if you can get better terms, such as a lower interest rate, to change from an adjustable-rate to a fixed-rate loan or vice versa, to shorten the term, to get cash out, or to stop paying mortgage insurance. 

You typically need to have had your mortgage loan for at least six months before you can refinance. 

Your credit score might go down slightly when you refinance. But if you make your payments on time every month, your score should go up again. 

You don’t get money when you refinance a home loan unless you’re applying for a cash-out refinance. This happens when you take out a new mortgage for more than what you owe. 

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