What Is Mortgage Refinancing? How Does It Work?

Vault’s Viewpoint on Mortgage Refinancing

• Refinancing a mortgage can lead to a lower interest rate and lower monthly payments.
• Several types of mortgage financing are available, including a rate-and-term loan and a cash-out refinance.
• Refinancing makes sense only if the financial gains offset the closing costs.

Mortgage Refinance 101

When you refinance a mortgage, you replace your old mortgage with a new one. You can do this with the same lender that originated the mortgage you have now, or you can explore the refinance with a new mortgage lender. In either case, part of the new mortgage’s loan proceeds get used to pay off your old mortgage in full. This way, you’re left with just one loan—and just one monthly payment. 

This contrasts with second mortgages like home equity loans and home equity lines of credit (HELOCs). Those second mortgage options let you borrow against the equity you have in your home, but they don’t impact your existing mortgage. With a HELOC or home equity loan, you’ll need to keep making your normal mortgage payments, plus payments for the new second mortgage. 

How Does Mortgage Refinance Work?

Maybe you’re looking to secure a lower interest rate, change your loan term or tap into your home’s equity. Whatever the reason, here’s how refinancing a mortgage works: 

• Application: You start by applying for a new mortgage with your current lender or a new lender. When you apply, you’ll provide financial information, such as income, assets, debts and credit history, similar to the process you went through to get your first mortgage. Your refinance lender will use this information to assess your eligibility for refinancing.
• Underwriting: The lender reviews your application to determine your creditworthiness and ability to repay the new loan. This process can involve an appraisal of your home to verify its value and ensure it meets the lender’s criteria.
• Approval: If approved, your mortgage lender will offer you a new mortgage, and you’ll receive a loan estimate that outlines the terms along with estimated closing costs.
• Closing: Once you agree to the new terms, you’ll go through a closing process where the new mortgage pays off your old one. This involves signing the new loan documents and covering any closing costs, which can include appraisal fees, title insurance and other expenses. According to Freddie Mac, closing costs could end up being 3% to 6% of your principal loan amount.

Here’s an example: Imagine you have a 30-year mortgage with a 7.25% interest rate and owe $200,000. If interest rates drop and you qualify for a mortgage with a rate of 6.3%, you could save a significant amount of money if you refinance to a new 30-year mortgage at the lower rate.

Original mortgage

• Principal: $200,000
• Interest rate: 7.25%
• Monthly payment: Approximately $1,364 (excluding taxes and insurance)
• Total interest paid over 30 years: About $291,166

Refinanced mortgage

• Principal: $200,000
• Interest rate: 6.3%
• Monthly payment: Approximately $1,238 (excluding taxes and insurance)
• Total interest paid over 30 years: About $245,660

By refinancing, you would reduce your monthly payments by about $126 and save around $45,500 in interest over the life of the loan.

Reasons To Refinance

Refinancing comes with a bunch of paperwork and closing costs, so it doesn’t always make sense to take out a refinance loan. If you’re considering a refi, ask yourself: What is mortgage refinancing going to accomplish for me? 

Here are a few reasons to refinance a mortgage.

Secure a Lower Rate

If current mortgage rates have dipped below the rate for your existing mortgage, refinancing enables you to take out a new mortgage and potentially score a lower rate and lower monthly payments. Even if rates haven’t budged much, if your finances have improved—say, your credit score increased or your income has climbed—you might qualify for a lower rate. Mortgage lenders, including your current one, can provide rate quotes to see whether you could benefit from a refi. Securing a lower rate means paying less in interest over the life of your loan and could lower your monthly mortgage payment.

Shorten Your Repayment Term

Perhaps a lower rate is not your primary motivation for refinancing your mortgage. Maybe you want to shorten the time it’ll take to pay off the loan.

You might decide to reduce the payoff period from 30 to 15 years, for instance. In this scenario, you’d normally qualify for a lower interest rate, which could lead to savings on interest over time. Keep in mind, though, the amount of your monthly payment is likely to go up. 

Switch to a New Lender

If you’re unhappy with the lender that holds your mortgage, refinancing allows you to explore working with a new lender. Before you dive in, though, ask your potential new lender, “How does mortgage refinancing work at your institution?” In particular, you’ll want to know whether it’ll sell your mortgage to a different company to service the loan, a common practice in the lending industry.

If you’re committed to refinancing because you want to do business with another lender, look for lenders that hang onto their loans after closing.

Change Your Loan Type

When you refinance a mortgage, you can switch from one type of mortgage loan to another. If you have an adjustable-rate mortgage (ARM), for instance, you can refinance to obtain a fixed-rate mortgage. By ditching the ARM, you eliminate the possibility that future rate hikes could boost your monthly payment. Or, if you’re confident rates will fall in the near future, you could refinance your fixed-rate mortgage as an ARM 

Types of Mortgage Refinancing

Several types of mortgage refinancing are available. They include:

• Rate-and-term refinance: This common type of mortgage refinancing generally changes the interest rate and payoff period for the loan.
• Cash-out refinance: With a cash-out refinance, you take advantage of the home equity you’ve accumulated to cover home improvements, debt consolidation or other needs.
• Cash-in refinance: A cash-in refinance lets a homeowner make a lump-sum payment to gain a smaller balance with a replacement mortgage.
• Streamline refinance: A streamline refinance of an FHA, VA or USDA mortgage lets you change the loan terms without a new home appraisal.
• No-closing-cost refinance: A no-closing-cost refinance allows you to avoid closing costs when you get a new mortgage. However, you don’t escape these costs altogether. Instead, they become part of the loan principal or are reflected in a higher interest rate.
• Short refinance. A short refinance loan is designed for borrowers who have fallen behind on mortgage payments; it helps borrowers avoid foreclosure.
• Fannie Mae high LTV refinance: This refinancing option is aimed at borrowers who are making on-time payments for a Fannie Mae mortgage, but their loan-to-value (LTV) ratio surpasses the maximum LTV permitted for a standard cash-out refi.

Get Cash

During a refinance, you might want to tap into some of the equity you’ve built up in your home. As noted above, with a cash-out refinance, you typically take out a new loan that’s bigger than your current mortgage. The lender then cuts you a check for the difference.

That said, a cash-out refi usually means resetting the clock on your mortgage, potentially with a higher interest rate than you had before.

The Consumer Financial Protection Bureau (CFPB) cautions that these cash-out refinances increase the risk of foreclosure. Still, because home values have risen so much in recent years, you might be able to cash out some of that growth without being burdened by a costly new mortgage.

Remove Someone From the Mortgage

Parting ways with your old mortgage also means letting go of some of its legally binding language. If you recently got a divorce and you want a new mortgage without your ex-spouse’s name on it, for example, refinancing can help you achieve that. 

The Cost of a Refinance

When you refinance a mortgage, you should expect to pay 3% to 6% of the loan amount in closing costs. That usually includes everything from application and origination fees to home appraisal and title services.

So, how much might it cost you to refinance?

Let’s say the lender charges closing costs around 4% of the loan. If you’re refinancing into a new mortgage of $300,000, for example, you should prepare to pay $12,000 ($300,000 x 0.04 = $12,000). You might not need to come up with this money in cash, though. Some lenders will let you roll closing costs into the new loan.

In our example, you would take out a new mortgage for $312,000. You’d then pay interest on those closing costs, which makes your loan more expensive overall. But if refinancing could deliver some serious financial gain for you and you don’t have the cash on hand to cover closing costs, this kind of no-closing-cost refinance could be right for you.

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When Does a Mortgage Refinance Make Sense?

Generally, it makes sense to refinance a mortgage only if you’ll stay in the house long enough to see financial gains that offset the closing costs. In many cases, this means staying in the house for at least five years after refinancing.

“Mortgage refinancing only makes sense if you’ll see some serious financial upside. Crunch the numbers and make sure they align with your long-term plans. If you think you might sell in the next five years, for example, you should probably skip the refi.”

— Kacie Goff

Many mortgage lenders provide online refinance calculators to help you crunch the numbers. You might also want to review the CFPB’s “Should I Refinance?” guide if you’re considering a refi.