How and Why to Refinance Your Mortgage

Definition of mortgage refinance

A mortgage refinance replaces your current home loan with a new one. Often people refinance to reduce the interest rate, cut monthly payments or tap into their home’s equity. Others refinance a home to pay off the loan faster, get rid of FHA mortgage insurance or switch from an adjustable-rate to a fixed-rate loan.

Let’s consider some important initial aspects of refinancing a mortgage — and then run through the process step by step.

How does refinancing work?

When you buy a home, you get a mortgage to pay for it. The money goes from the lender to the home seller. When refinancing a home, you get a new mortgage. Instead of going to the home’s seller, the new mortgage pays off the balance of the old home loan.

Mortgage refinancing requires you to qualify for the loan, just as you had to meet the lender’s requirements for the original mortgage. You file an application, go through the underwriting process and go to closing, as you did when you bought the home.

» MORE: Shop top mortgage refinancing lenders

Why and when you should refinance a home

Before you begin, consider why you want to refinance your home loan. Your goal will guide the mortgage refinancing process from the beginning.

• Reduce the monthly payment. When your goal is to pay less every month, you can refinance into a loan with a lower interest rate. Another way to reduce the monthly payment is to extend the loan term — say, from 15 years to 30. The drawback to extending the term is that you pay more interest in the long run.

• Tap into equity. When you refinance to borrow more than you owe on your current loan, the lender gives you a check for the difference. This is called a cash-out refinance. People often get a cash-out refinance and a lower interest rate at the same time.

• Pay off the loan faster. When you refinance from a 30-year mortgage into a 15-year loan, you pay off the loan in half the time. As a result, you pay less interest over the life of the loan. There are pros and cons to a 15-year mortgage. One downside is that the monthly payments usually go up.

• Get rid of FHA mortgage insurance. Private mortgage insurance on conventional home loans can be canceled, but the Federal Housing Administration mortgage insurance premium you pay on FHA loans cannot in many cases. The only way to get rid of FHA mortgage insurance premiums is to sell the home or refinance the loan when you have accumulated enough equity. Estimate your home value, then subtract your mortgage balance to calculate your home equity.

• Switch from an adjustable- to a fixed-rate loan. Interest rates on adjustable-rate mortgages can go up over time. Fixed-rate loans stay the same. Refinancing from an ARM to a fixed-rate loan provides financial stability when you prefer steady payments.

» MORE: When is the best time to refinance?

Refinance into another 30-year home loan?

Reducing your monthly payment is usually the goal. And it’s tempting to refinance with another full 30-year term to lower your mortgage payment. But that means you’ll end up taking even longer to pay off your house and paying more interest over the long run.

Instead, you can ask the lender to match your remaining loan term. For example, if you’ve had a 30-year loan for three years, you have 27 years remaining. You can tell the lender to set up the payments so you repay the refinanced loan over 27 years instead of 30. This way, you reduce the interest you pay over the life of the loan. This is mortgage amortization at work.

» MORE: See today’s refinance rates

Use a mortgage refinance calculator

Once you’ve decided to refinance, it’s time to crunch the numbers. Using a mortgage refinance calculator can help you shop for the best mortgage.

You’ll need to know (or make some educated guesses about) your new interest rate and your new loan amount.

After you input the data, the tool will calculate your monthly savings, new payment, and lifetime savings, taking into account the estimated costs of refinancing your home.

It also will show your refinance “break-even” point. Getting a mortgage generally requires paying fees, often amounting to thousands of dollars. It takes a while for a refinance to break even — that is, for the accumulated monthly savings to exceed the refinance closing costs.

Working with a refinance calculator will give you a good idea of what to expect. Even better, when you have a few estimates from mortgage lenders you can enter the terms they offer you into the calculator to help determine which one offers the best deal.

» MORE: How to maximize your mortgage refinance savings

Shop the best refinance rates

Now for a little legwork — or more likely web work and phone calls. You want to shop for your best refinance rate and get a Loan Estimate from each lender. Each potential lender is required to issue the estimate within three days of receiving your basic information.

The Loan Estimate is a simple three-page document that details the loan terms, projected payments, estimated closing costs and other fees.

Compare the loan details from each lender and decide which one is best for you. This is a good time to work that mortgage refinance calculator.

Refinancing a mortgage, step by step

Ready to tackle the refinance process? Go!

1. Set your goal. Reduce monthly payments? Shorten the loan term? Get rid of FHA mortgage insurance?

2. Shop for the best mortgage refinance rate. Keep an eye on fees, too.

3. Apply for a mortgage with three to five lenders. While the first lender's credit check will likely decrease your score slightly — often less than five points, according to FICO — subsequent inquires let lenders know you're rate-shopping, and shouldn't hurt your score further. Submit all applications within a two-week period to minimize the impact on your credit score.

4. Choose a refinance lender. To pick the best offer, compare the Loan Estimate document each lender provides after you apply. The Loan Estimate will tell you how much cash you’ll need for closing costs.

5. Lock your interest rate. When you lock the interest rate, it can’t be changed during a specified period. You and the lender will try to close the loan before the rate lock expires.

6. Close on the loan. This is when you’ll pay those closing costs that were listed in the Loan Estimate and again in the Closing Disclosure. Closing on a refinance is like closing on a purchase loan, with one main difference: No one hands you the keys to the home at the end.