How does refinancing a mortgage work?

People refinance their mortgage for a variety of reasons.

When you refinance debt, including mortgages, you apply for a new loan and use the borrowed money to pay off your original loan.

Often the funds move from one lender to another without you ever touching it. Ideally, you’ll qualify for a new loan with more favorable terms than your current loan.

On the other hand, if you have a mortgage with an adjustable rate and plan to stay in your home, you might want to refinance to lock in a fixed interest rate.

Lowering your monthly payments aside, there are many reasons why homeowners refinance.

Maybe rates are low, or you’ve improved your credit health and you think you can get a lower interest rate. Or you have a Federal Housing Administration (FHA) loan and want to refinance so you can cancel the monthly mortgage insurance premium.

Or perhaps you got divorced and want to refinance to remove one person’s name from the mortgage.

Whatever your reason, have a goal in mind before starting the refinancing process.

One couple’s refinancing experience

Jake Bramhall and his wife were looking for a way to save money – and they found one. By refinancing their home’s mortgage, they were able to lower their interest rate several percentage points and save around $750 each month.

They decided to refinance their 30-year fixed-rate mortgage (about $370,000) with a five-year adjustable-rate mortgage (ARM). The ARM would have the low interest rate for five years, and then it could climb higher. An adjustable interest rate can be risky, but they’d already taken that into consideration.

“The kids were getting ready to go to college, and my wife and I knew that we would sell the house in under five years,” says Bramhall, chief operating officer of Orbix360, a photo-publishing platform. “We did end up selling that house in the third year of the new loan.”

Your situation might be different than the Bramhalls’, but understanding mortgage refinancing could open up other opportunities.

There are several common types of refinancing.

According to Erin Lantz, vice president of mortgages at Zillow Group, refinancing arrangements are often characterized in a few ways, including:

• Rate-and-term. A rate-and-term refinance doesn’t involve changing the principal balance of the loan — just the interest rate, repayment term or both.
• Cash-out. With a cash-out refinance, your new loan will be larger than your current balance, and you’ll receive the difference as cash. Some people do this to pay down debt or renovate their home.
• Cash-in. You may be able to put more money down while refinancing to help secure a lower interest rate and shorter term. Doing so could also eliminate a mortgage insurance requirement on your new loan.

Regardless of which type you choose, refinancing a home can be a relatively simple process, says Kevin Quinn, senior vice president of retail lending at First Internet Bank. However, you may want to spend time comparing mortgage lenders before submitting applications.

Refinancing isn’t usually as complicated as the homebuying process, but some aspects might look familiar to you.

For example, you’ll likely need a home appraisal, credit check, proof of income and a variety of supporting documents to apply for your new mortgage. And there are often closing costs associated with refinancing.

How to decide if refinancing makes financial sense

You probably won’t know the exact terms of your new loan until you begin submitting applications. However, you can estimate the benefit of refinancing based on approximate closing costs, your home’s value and the potential change in the loan’s terms based on your creditworthiness.

There are mortgage refinance calculators that can do the heavy lifting and help you determine when the savings will cover the costs.

According to Lantz, one of the most important things to consider is the break-even point and how it compares to how long you plan to stay in the home.

To find your break-even point, divide your total costs by your monthly savings. The result will be how many months it takes for the savings to cancel out your refinancing expenses.

Refinancing can cost thousands of dollars, and even if your monthly payment drops, it might not be worth it if you plan to move before recouping the cost.

The loan shopping and application process

If you decide that refinancing makes sense, consider shopping mortgage lenders to find the one that offers the best terms. However, try to shop lenders within 14 to 30 days to minimize the impact on your credit score.

Before you start shopping, gather the documents you’ll need for the applications. Often you’ll have to share tax returns or W-2 forms to prove your income and copies of your homeowners insurance, title insurance, bank or brokerage statements, and other financial documents.

You might be able to start, and in some cases complete, the entire application process online.

Lenders must send you a Loan Estimate that lists the approximate closing costs, terms and monthly payments of the new loan within three business days of receiving your application. You can use these forms to compare offers from different lenders and decide which to accept.

“All told, a refinance typically takes 45 days from the time of the application to approval and closing,” Quinn says.

That’s because after accepting an offer, you still may need to schedule a home appraisal, and the lender needs to closely review your application and supporting documents. After the underwriting process is complete, you’ll receive the official terms of your new loan and be able to finalize the deal.

Bottom line

Refinancing your mortgage could offer a variety of benefits, including lowering your interest rate or monthly payment, or allowing you to take cash out of the equity you’ve built in the home.

While the refinancing process isn’t always complicated, it can be drawn-out and costly. Before you dive in, determine the potential costs and benefits and then shop mortgage lenders to find the best terms possible.