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What is a mortgage refinance?

Refinancing a mortgage is the process of applying for a new mortgage to replace an existing one. The new mortgage pays off the old loan, and in most cases, the new loan has better terms. 

However, a refinance isn’t as simple as calling your bank and asking for a new loan. Here’s what you need to know about refinancing a mortgage.

How does refinancing a mortgage work?

Mortgage refinancing is similar to getting an original home loan. You likely remember submitting a loan application, providing the bank with supporting documentation, and waiting for an appraisal. You’ll repeat most (if not all) of these steps when refinancing.

Having an existing home loan doesn’t guarantee an approval for refinancing, though. Even if you refinance with your current lender, the bank will likely re-check your credit and review your most recent income information. 

Keep in mind, too, many refinances also involve closing costs. These are lender and third-party fees related to the mortgage. You can pay closing costs out-of-pocket, or wrap the costs into your mortgage loan – if you have enough equity. The latter method, however, increases your mortgage balance. 

Typically, closing costs are about 2% to 5% of the loan balance. This is need-to-know information, as it helps decide whether it makes sense to refinance. 

Ideally, you should live in the home long enough to recoup this cost. For example, if you pay $5,000 in closing costs and refinancing saves $200 a month, you should live in the property for at least another 25 months to break even. 

Common reasons to refinance a mortgage

Why do some homeowners refinance their mortgage loans? Here’s a look at common reasons:

• Get a lower interest rate. When mortgage interest rates drop, many homeowners make a mad dash to refinance their home loans. A lower mortgage rate can reduce their monthly mortgage payment. They can use the savings to build an emergency fund, make home improvements, or pay off debt.
• Change mortgage terms. Some people refinance and switch from a 30-year mortgage to a 15-year mortgage, or vice versa. They can also switch from an adjustable-rate mortgage to a fixed-rate mortgage, or from an FHA mortgage to a conventional mortgage.
• Cash out equity. Depending on their amount of home equity, homeowners can also refinance and borrow cash from their equity – typically up to 80%. 

What to know before refinancing a mortgage?

Before refinancing your mortgage, understand that your credit history, employment history, and equity determines whether you’ll qualify. 

Mortgage programs vary, but you typically need a minimum credit score between 580 and 620 to get approved for a new loan. The lender will also ask for tax returns or W-2s from the past two years, and you’re often required to submit other documentation such as bank account statements.

Refinancing with the purpose of getting a lower interest rate is attractive, but it’s not guaranteed. Your credit history ultimately decides your mortgage rate, and only borrowers with the highest scores qualify for the most favorable rates. 

But even if you get a better interest rate, refinancing might extend your mortgage term. In which case, you might pay more interest in the long run. This can happen if you reset the clock and refinance for another 30 years. To avoid overly extending your mortgage term, consider refinancing for 15 years or 20 years.

Check your credit history before applying for mortgage refinancing, at least a few months before, if possible. 

Take steps to improve your credit score such as paying down credit card debt and other loans. It’s also vital to compare mortgage rates.

You can refinance the mortgage with your current lender. But as a general rule of thumb, get at least three quotes from different banks to compare rates and terms.

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Refinancing a Mortgage FAQ

What does it mean to refinance a mortgage?

Refinancing a mortgage involves replacing your current home loan with a new one, often to secure better terms such as a lower interest rate or different repayment schedule. It’s essentially restructuring your home loan to potentially save money or better align with your financial goals and circumstances.

Is it hard to refinance a mortgage?

Refinancing a mortgage can involve some paperwork and fees, but it’s not inherently difficult, especially if you have a good credit score and stable finances. The process typically requires gathering necessary documents, submitting an application, and undergoing a credit check and appraisal. While it may take some time and effort, many people find that the potential benefits outweigh the challenges.

Is it a good idea to refinance a mortgage?

Deciding whether to refinance a mortgage depends on individual circumstances. Factors to consider include current interest rates, your financial goals, and how long you plan to stay in your home. If you can secure a lower interest rate or better loan terms, refinancing may save you money on monthly payments or overall interest costs. However, it’s essential to weigh potential savings against any fees or other expenses associated with refinancing.