Mortgage Refinancing: How It Works and When It Makes Sense

Mortgage refinancing lets you save money or tap equity, but it takes time to break even after upfront costs.
Holden Lewis
Hal M. Bundrick, CFP®
By Hal M. Bundrick, CFP® and  Holden Lewis 
Updated
Edited by Alice Holbrook Reviewed by Michelle Blackford

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Nerdy takeaways
  • When you refinance, you get a new mortgage to replace your old one. You usually pay closing costs and fees.

  • Set a goal first. For example: Lower your interest rate, tap home equity or pay off your loan faster.

  • Just like shopping for a purchase loan, it pays to compare lenders to get the best refinance mortgage rate.

What is a mortgage refinance?

A mortgage refinance replaces your current home loan with a new one. Often, people refinance to reduce their interest rate, cut their 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 typically pay for it with a mortgage. The lender pays the money to the home seller, then you pay the lender back, typically monthly.

When refinancing a home, you get a new mortgage. Instead of the lender paying the home’s seller, it pays off the balance of your old home loan. You’ll pay the lender back based on the amount of your new mortgage.

Similar to getting a purchase mortgage, refinancing requires you to file an application, go through the underwriting process and close.

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When to refinance a mortgage

Simply put: If mortgage rates are lower now than they were when you bought your house, a refinance could save you money — and that’s when it makes the most sense. With a lower interest rate, your monthly mortgage payment will be lower.

Conversely, even if you intend to refinance for another reason — such as to get rid of your FHA mortgage insurance premium — you’ll want to do some math if rates have gone up since you bought your home. Depending on how much rates have increased, you may be better off sticking with your original mortgage.

Mortgage rates fluctuate with market forces, so you can’t control when the rates go down. However, some factors within your control — like your credit score — impact the rates lenders offer you. So if your credit score is better now than when you bought your house, that’s another way you can potentially refinance to a lower rate.

Here are some common situations when you might consider refinancing.

Reduce the monthly payment

When your goal is to pay less every month, you can refinance into a loan with a lower interest rate. A rate and term refinance is a good fit for this goal.

Pay off the loan faster

When you refinance to a shorter term, such as from a 30-year mortgage into a 15-year loan, you pay less interest over the life of the loan, but monthly payments usually go up. If you’d like to pay off your loan faster, but rates have risen, consider making extra payments on your current loan.

Lengthen the repayment term

On the flip side: You could extend the loan term — say, from 15 years to 30 — to lower your monthly payment. However, you’ll end up taking even longer to pay off your house and paying more interest over the long run. There are other ways to lower your monthly mortgage payment if you’re facing financial hardship, so consider the pros and cons before refinancing to a longer term. (And keep in mind that, if rates are higher now than when you bought your home, your savings might be impacted.)

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. Depending on your credit score and rates when you refinance, it’s possible to get a cash-out refinance and a lower interest rate at the same time.

🤓Nerdy Tip

What if refinance rates aren’t in your favor when you want to tap equity? Consider opening a home equity line of credit (HELOC). This lets you draw on your home equity as needed. You can pay all or some of it back monthly, similar to a credit card.

Get rid of FHA mortgage insurance

Private mortgage insurance on conventional home loans can be canceled, but in many cases, the Federal Housing Administration mortgage insurance premium you pay on FHA loans cannot. If your FHA mortgage insurance premiums will last for the term of your loan, you can get rid of them if you refinance to a conventional loan when you have accumulated at least 20% equity. To calculate your home equity, estimate your home value, then subtract your mortgage balance.

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.

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How much does it cost to refinance a mortgage?

Refinancing fees and closing costs are similar to the percentages you’d pay for a purchase mortgage. Typically, they cost 3% to 6% of your outstanding principal balance.

For example: If you still owe $200,000 on your home, expect to pay $6,000 to $12,000 in refinance fees. Costs vary by lender, so shop around to get the best deal.

You might also be on the hook for extra fees from your current lender. Read the fine print in your purchase mortgage to see if you’ll owe a mortgage prepayment penalty. Some lenders charge a fee if you pay off your mortgage in full in the first three to five years after getting the loan.

How to find the best refinance rates

Once you’ve decided to refinance, it’s time to crunch the numbers and find the best deal.

  • Shop around: Find your best refinance rate by getting a Loan Estimate from at least three lenders. 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 your estimated loan terms, payments, closing costs and other fees.

  • Use a mortgage refinance calculator: Once you’ve picked the best offer, compare the new terms to those of your existing mortgage. A refinance calculator can help you determine how much you’ll save on your monthly payment or total mortgage interest over time.

  • Calculate your “break-even” point: Getting a mortgage generally requires paying fees, often amounting to thousands of dollars. It can take a few years for a refinance to break even — that is, for the accumulated monthly savings to exceed the refinance closing costs.

🤓Nerdy Tip

If you’re planning to move soon, it might not make sense to refinance. It could take a few years to break even from upfront closing costs and fees.

Refinancing a mortgage, step by step

Ready to tackle the refinance process?

  1. Set your goal. Want to reduce monthly payments? Shorten the loan term? Get rid of FHA mortgage insurance? The answer will help determine whether you should refinance — and, if you should, which product is best.

  2. Shop for the best mortgage refinance rate. 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 inquiries 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.

  3. Choose a refinance lender. To pick the best offer, compare the Loan Estimate documents each lender provides after you apply. It will tell you how much cash you’ll need for closing costs. Keep an eye on fees, too.

  4. Consider locking in your interest rate. You might have to pay a fee, but 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.

  5. 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 loan is like closing on a purchase loan, with one main difference: No one hands you the keys to the home at the end.

» MORE FOR CANADIAN READERS: How to refinance a mortgage

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