Reader-friendly guide to mortgage refinancing
If you're a homeowner, chances are very good that you're going to refinance a mortgage at some point. But when should you refinance? And why? And what does refinancing a home loan involve?
This guide provides an overview of mortgage refinancing the reasons to do it, the pros and cons, how to go about it, what to look out for and other essential information. Each is presented in short, easy-to-read sections. You can read through the whole thing or skim through to pick out the topics you're most interested in.
You'll also find break-out links to more detailed explanations of key points, so you can explore that information at your own pace.
Where to start? How about with the first thing to know about refinancing a mortgage?
What is a Refinance?
Basically, you're taking out a new mortgage and using the proceeds to pay off your old one. In other words, you're trading out your old mortgage for a brand new one with more favorable terms.
What does mortgage refinancing do for me?
When you refinance a home loan, you can
- Take advantage of low mortgage refinance rates to reduce your monthly mortgage payments.
- Shorten the term of your mortgage to pay it off faster and save on interest costs.
- Or lengthen your mortgage to spread out the costs for lower monthly charges.
- Change from an adjustable-rate mortgage to a fixed-rate mortgage or vice versa.
- Combine a home equity loan and your current mortgage into a single loan and monthly payment
- Do a cash-out refinance to get funds for home renovations, college tuition, medical costs, paying off debts or other expenses.
Basically, refinancing a mortgage allows you to 1) trade in your old mortgage for a new one with more favorable terms or 2) borrow against your home equity and consolidate that debt into your mortgage. Or do both.
What is mortgage refinancing?
At its simplest level, to refinance a mortgage means replacing your current mortgage with a new one. You use the new mortgage to pay off the old one, and you go forward with the new mortgage's rates and terms.
Your mortgage loan refinance may have a lower interest rate and lower monthly payments than your old one did. Or a shorter term so you can pay it off faster, or various other advantages.
Since you're taking out a new mortgage, you'll go through most of the same steps you did when taking out your first mortgage. You'll need to be qualified based on your income, credit and debt load, and the home will need to pass an appraisal, though some of these may be waived under certain conditions.
How is refinancing different from my original mortgage?
Actually, they're very similar. You go through the same process of applying for the loan and pay many of the same fees. The main difference is you're not buying a home this time around.
When refinancing a mortgage loan, you don't have to refinance with the same lender that currently holds your mortgage - you can shop around for the best refinance rates and terms. But you can refinance with the same lender as well.
More information: Finding the best refinance rates
When does it make sense to refinance my mortgage?
"Should I refinance my mortgage?" It's a major financial decision. Here are a few ways to know if it would be a good choice for you.
- If refinance mortgage rates are lower than what you're currently paying on your loan - a full percentage point is a good rule of thumb.
- If you have an ARM (adjustable rate mortgage) and are concerned that rates may rise.
- If you've had your mortgage for a number of years and would like to do a loan refinance to a shorter term, to pay it off faster and reduce your long-term interest costs.
- The lowest refinance rates are given to those with the best credit, so if your credit score has improved since you first took out your mortgage, you might now qualify for a better rate.
- If you have greater than 20 percent equity and wish to eliminate FHA or lender-paid mortgage insurance.
- If you have a home equity loan or other second mortgage and would like to consolidate it with your primary mortgage.
More information: What are the benefits of refinancing a mortgage?
When is it not a good time to refinance?
There are some situations where it might be a good idea to avoid refinancing a home, at least for the time being. Among them are:
- If mortgage refinance rates aren't low enough to justify it. If you can only reduce your rate by half a percentage point, it's going to take a long time for your savings to exceed your closing costs.
- If you expect to move in a few years, so you won't be in the house long enough for your savings to exceed your closing costs if you refinance your home.
- If you've only got a few years left on your mortgage, so that you're no longer paying much in interest anyway.
- Your current home loan has a prepayment penalty you'll have to pay if you refinance.
- If your credit has taken a major hit since you obtained your mortgage and has yet to recover.
More information: What are the downsides of refinancing a mortgage?
Should I refinance my mortgage?
The key is to determine your "break-even" point, the length of time it will take your savings from a home loan refinance to exceed what you paid in closing costs. You figure how much your lower rate will save you each month, then divide your total closing costs by that figure to determine how many months it will take you recover your expenses.
It's easy to do this using an online refinance calculator, which lets you determine what your monthly payments would be for any refinance loan amount and mortgage rate. Some of them will even calculate the break-even point for you.
The main thing is that you want to be sure you'll stay in the home long enough to recoup the entire cost of a home mortgage refinance. You also want to break even in a reasonable amount of time - saving $75 a month may not be worth it if it takes you 10 years to break even.
What does it cost to refinance?
Refinance rates are only part of the
As noted above, you can expect to pay anywhere from 3-6% of your outstanding principal in fees when refinancing mortgage loans. The higher range is normally associated with paying for discount points to obtain a lower mortgage rate.
There are a variety of closing costs, but the most common are:
- Application Fee
- Loan Origination Fee
- Discount Points
- Appraisal Fee
- Title Search Fee
- Title Insurance Fee
The amounts charged for first three are within your lender's control; the others are not. If you have good credit, you may be able to negotiate lower application fees, loan fees, and discount points. In any event, discount points are always optional for the borrower.
Lenders are often willing to roll closing costs into the loan amount when they refinance home loans, so you don't necessarily have to pay them up front. However, doing so will raise your loan balance and monthly payments.
More information: What fees will you pay to refinance your mortgage?
What about a no-cost refinance?
A "no-cost" refinance is a bit of a misnomer. You still pay closing costs, you just do it in a different way.
In a no-cost refinance, your lender pays your closing costs for you. To compensate, they charge you a higher mortgage rate. So the extra interest eventually makes up for what you would have paid in closing costs.
In a situation like this, the lender wants to make sure they get their money out of the deal before you sell the home or refinance again. So this type of loan will often include a prepayment penalty covering the first few years to make sure the lender gets paid.
The downside of a no-cost refinance is that you're stuck with that higher rate for the life of the loan. So unless you sell the home or refinance again, the long-term expense is considerably higher than paying your closing costs up front.
More information: No Cost Refinance
What are the potential benefits of refinancing?
- Lower interest rate
- Lower monthly payments
- Shorten or lengthen your mortgage term
- Convert from adjustable to fixed-rate mortgage
- Borrow money with a cash-out refinance
How is refinancing different from getting your original mortgage?
So how to refinance a mortgage? As noted above, the home refinance process is very similar to the one you went through when getting the mortgage to buy your home. The main difference is that you don't have the elements associated with transferring ownership of the property.
Refinance mortgage rates are pretty much the same as those for buying a home - you really don't get a higher or lower figure because it's a refinance rate.
You need to be qualified based on your credit, income and debt levels, and the home must assess for a sufficient amount to justify the loan. Instead of a down payment, your accumulated home equity represents your personal investment in the loan.
In some cases, some of these requirements may be waived. See the descriptions for HARP and Streamlined Refinances, below.
Qualifying to refinance
Qualifying to refinance is much like qualifying for your original mortgage - you go through most of the same steps, aside from those used to transfer ownership of the property.
The main criteria are your credit, debt-to-income level and amount of home equity.
A credit score of 740 will help you get you the best refinance rates. Costs tend to get higher as your score drops into 600s. Borrowers with sub-600 scores will find it difficult to refinance outside of high-cost specialty lenders.
Lenders will want to see that you've had a steady source of income over the past two years. Your debt-to-income ratio, the minimum payments for your new mortgage and other debts, should not exceed 43 percent of your gross monthly income. Depending on your credit, this figure could range from 36 to 50 percent.
Your home will likely have to undergo an appraisal to determine its value. Lenders usually want you to have at least 20 percent home equity - the share of your home's value that's paid off - before they'll approve you for home refinancing.
FHA and VA borrowers with less than 20 percent equity may still be able to obtain a streamlined refinance, while Fannie Mae/Freddie Mac borrowers with low or negative equity may be able to get a HARP refinance. See "Types of mortgage refinancing, below."
More information: Do I qualify to refinance my mortgage?
Types of home mortgage refinancing
There are several ways to refinance your mortgage, depending on your situation and reasons for refinancing. While the basic rule remains the same - you're replacing one mortgage with another - the different types can make it easier to refinance for some people, or allow you to improve your financial situation.
This is the most common type, where you're looking to take advantage of lower mortgage rates, change your loan type (ARM to fixed-rate or vise versa) or change your loan term to a shorter or longer payoff than you presently have.
This is a combination of refinancing and a home equity loan, all rolled into one. You receive a check at closing, and your new loan balance is increased by the amount you borrowed as a result (See below).
This is simply a cash-out refinance where you use the money you receive to pay off other debts, typically ones with higher interest rates and shorter repayment terms.
This when you use refinancing to pay off a home equity loan, HELOC, piggyback loan or other second mortgage into a single primary home loan. It's like a cash-out refinance, but you're not reducing your home equity because those other loans already used your home as collateral.
Officially known as the Home Affordable Refinance Program, this is a special type of refinance for homeowners with Fannie Mae- or Freddie Mac-backed mortgages with low or negative equity (i.e., underwater on the loan). It allows you to refinance without an assessment of the home's current value. Expires at the end of 2016.
More info: An in-depth guide to HARP 2.0
An option available to FHA and VA mortgage holders that allows them to refinance to current market rates as long as they've kept up on their mortgage payments. No need to verify credit, income, debts or the value of the home.
More info: Streamline refinancing
Should I refinance?
Be sure to weigh your long-term savings from refinancing against the upfront fees you have to pay to get the loan. If it takes too long to reach the "break-even" point, refinancing might not be worthwhile.
What is a cash-out refinance?
With a cash-out refinance, you can borrow money and refinance your mortgage at the same time. You do this by borrowing against your accumulated home equity.
Suppose you own a $300,000 home and owe $100,000 on the mortgage. You might use a cash-out refinance to borrow $50,000, which would give you a new mortgage with a balance of $150,000.
There are several reasons for doing this. 1) Mortgages have some of the lowest interest rates of any type of consumer borrowing 2) Mortgage interest is generally tax-deductible 3) Mortgage payments can be extended over 30 years, longer than most other types of consumer debt and 4) You may be able to reduce your overall mortgage rate in the process.
You can use the funds for any purpose you wish. Popular reasons are for home repairs or improvements, paying off credit cards or other high-interest debt, education expenses, or starting a business.
More information: How does a cash-out refinance work?
What are the tax implications of refinancing?
A refinanced mortgage is still a mortgage, so the same rules for deducting mortgage interest on your taxes still apply. You can deduct the interest paid on up to $1 million in mortgage debt used to buy, build or purchase a home as a couple, or up to $500,000 for a single.
But on a cash-out refinance, other rules apply if you use the proceeds for some other purpose than home improvements or repairs. In that event, the additional funds borrowed are considered a home equity loan for tax purposes. You can still deduct interest paid, but the limits are lower - up to $100,000 in home equity debt for a couple, $50,000 for a single.
Refinancing to a lower mortgage rate reduces the amount of interest you pay, so it will reduce the amount of interest you can deduct as well. So plan on taking a smaller deduction when tax time comes.
More information: What are the tax implications of refinancing a mortgage?
How often can you refinance?
You can refinance as often as you wish. But as a practical matter, there are a few obstacles to doing it frequently.
First, lenders are reluctant to refinance a mortgage too soon after the last one was approved. If it's been less than a year, they'll likely take an extra-close look at the application. Unless there's been a large rate drop, or some other development that clearly makes it in your interest to quickly refinance again, they'll wonder if something's afoot.
Some mortgages also have prepayment penalties that kick in if you refinance or pay off the loan within the first few years. Though these are not as common as they once were, they can make refinancing unattractive as long as they are in force.
The biggest limit, though, is that it simply doesn't pay to refinance too often. Each time you do, you're paying that 3-6 percent in closing costs - and that can add up if you keep refinancing in pursuit of small decreases in your interest rate.
A good rule of thumb is that you want to be able to be able to save at least a full percentage point when refinancing to a lower rate - less than that, and you may be spending too much to save too little.
Hopefully this has taken some of the mystery out of refinancing home mortgage loans. While the process may seem intimidating at first, the concept itself is fairly simple - trading one mortgage for another one. But doing that opens up a world of options that make it a potentially powerful tool for managing your personal finances, improving cash flow and saving money.
Ready to get started? Take a big step towards renovating your finances by looking into home refinance options today!
More Refinance Articles & Resources
- Streamline Refinancing
- No Cost Refinance
- Refinancing FAQ
- FHA Refinance
- Should I refinance my home mortgage?
- Federal Reserve (external)
- U.S. Department of Housing and Urban Development (external)
- U.S. Department of Treasury (external)
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