Mortgage Refinancing: What It Is, How It Works, and When to Do It

You own a house and have been paying down your mortgage loan. But maybe it feels like time for a reset so you can make home financing work for your changing needs and — hopefully — save more money over the long term. Now could be the ideal time for a mortgage refinance.

How does refinancing a mortgage work? What happens when you refinance your home? Who are good candidates for doing so, and what are some worthy reasons to consider a refi? What refinance options are available? And what are the steps involved? 

Read on for answers and important information that can help you make a more informed financial decision.

Key Takeaways

• Mortgage refinancing allows homeowners to replace their current loan with a new one, potentially offering lower interest rates, modified terms, and/or access to home equity.
• Refinancing can help reduce monthly payments, shorten loan terms, or consolidate debts, but it may come with fees and require meeting eligibility criteria.
• Common reasons to refinance include lowering interest rates, removing mortgage insurance, converting to a fixed-rate loan, or tapping into home equity for major expenses.
• While refinancing offers financial benefits, it may also increase total interest costs, reset loan terms, or reduce home equity, so carefully consider the timing.

What is Mortgage Refinancing?

Mortgage refinancing involves replacing your current mortgage with a new loan, typically to secure better financial terms, modify the loan structure, or access home equity.

“With a refinance, you are essentially paying off your old loan with a new one, which can potentially save you money over time or make monthly payments more affordable,” explains Dennis Shirshikov, a professor of finance and economics at City University of New York/Queens College.

You can refinance with your existing lender or a new lender. The process can often take 30 to 45 days and involves several steps as well as meeting eligibility requirements, which we will cover shortly.

Reasons to Refinance a Mortgage

There are many good reasons for borrowers to consider refinancing their mortgage loans. Let’s explore each of these common motives and goals.

Lower Your Interest Rate

Perhaps the biggest reason many borrowers choose to refinance is to lower their interest rate. A lower rate can reduce monthly payments and save significantly on total interest costs.

“For example, if you have a 30-year mortgage at a 7% interest rate and current rates drop to 6%, refinancing could reduce your monthly payments significantly,” adds Shirshikov.

This reason is “especially attractive in a low-interest rate environment, as even a small reduction can make a noticeable impact on overall costs,” says Carl Holman with A&D Mortgage. Here’s a quick look at how refinance interest rates are trending now:

How we source rates and rate trends

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Rate data in the charts and tables above comes from RateUpdate.com. The displayed rates come from multiple providers and represent market averages. Your mortgage rate will differ based on individual factors like your credit score as well as differing loan types and terms offered by lenders.

Adjust Terms

Refinancing can also let you adjust the loan duration. For example, refinancing from a 30-year to a 15-year term helps you pay off the loan faster and reduces interest but may increase monthly payments. Conversely, extending the term lowers monthly costs, useful if financial circumstances have shifted.

Convert Loan Types

If you currently have an adjustable-rate mortgage (ARM), you’re aware that your interest rate can fluctuate over time, often leading to higher mortgage payments. However, refinancing that ARM to a fixed-rate loan can offer payment stability, especially if you anticipate rising interest rates.

Consolidate Debts

“Debt consolidation refinancing is a strategy where borrowers can combine high-interest debts – like credit cards or personal loans – into their mortgage,” continues Holman. “This is often possible with a cash-out refinance, which allows borrowers to tap into their home’s equity to pay off these debts. The advantage is that mortgage rates are usually lower than those of other consumer debts, so this can reduce overall interest costs and simplify mortgage payments.”

Access Home Equity in Cash

A cash-out refinance is a loan option that allows homeowners to replace their existing mortgage with a new one and take out equity from their property in the form of cash, according to Sean Grzebin, head of Consumer Originations at Chase Home Lending. Here, the borrower refinances their loan for a larger amount, and the difference is paid to them in cash at closing.

A cash-out refinance can provide funds for significant expenses, like home improvements, which can boost your home’s value and may yield returns in the future. Similarly, you might want to invest in further education, which might later lead to a higher salary. 

“Let’s say your home is appraised for $200,000 and you owe $100,000 on your mortgage,” Grzebin continues. “That means you have about $100,000 in home equity. With this example, you may be approved for a cash-out refi up to 80% of the appraised value of your home – or $160,000. Paying off your existing mortgage would leave you with $60,000 in cash.”

Remove Private Mortgage Insurance (PMI)

If you originally were required to pay private mortgage insurance (PMI) due to making a down payment of less than 20%, refinancing after reaching a 20% equity position can eliminate this expense and lower monthly payments. This is actually a common tactic for FHA loan borrowers who want to refinance to a conventional loan, as all FHA loans require paying PMI.

“PMI removal becomes particularly attractive when property values appreciate substantially, which means your equity position also increases,” says Lorelie Abedes with Click Cash Homebuyers.

Pros and Cons of Refinancing

The primary benefits of refinancing include:

• Lowering your interest rate if you can lock in a lower rate. “Interest rates are always changing. If rates drop or your financial situation has improved, you could qualify for better rates and terms than you may currently have,” says Grzebin.
• Reducing monthly payments, which can be accomplished by lowering your rate or increasing your loan term
• Shortening your loan term, which means you’ll pay less in overall interest over the life of the loan
• Tapping into equity for financial objectives, which can be accomplished by opting for a cash-out refinance. “Maybe you want to save for college or retirement, make home renovations, or buy that big-ticket item you’ve been thinking about. A cash-out refinance can provide the cash you may need for your current goals,” Grzebin adds.
• Payment stability is achieved when you switch from an ARM with an unpredictable fluctuating rate to a predictable fixed-rate mortgage where the monthly principal and interest payments will not change.

On the downside, the experts caution that a loan refi can have its drawbacks, too, such as:

• Steep closing costs. Fees like lender charges, appraisal costs, and title insurance can total 2-5% of the loan, taking years to recoup through savings. “If you are planning to move in the near future, these closing costs might outweigh the benefits,” warns Shirshikov.
• Higher monthly payments. Refinancing to a shorter term, like a 15-year mortgage, could result in higher monthly payments, potentially straining your budget.
• Higher interest costs. Prolonging your loan term may lower monthly payments but increase total interest over time, raising the overall cost.
• Decreasing equity. Choosing a cash-out refi and borrowing against home equity lowers your ownership stake and can be risky if property values drop. “There is always the possibility you might owe more than what your home is worth if your property value decreases,” says Grzebin.
• Loan term reset. Refinancing restarts the loan term, possibly postponing full homeownership if you’ve already paid down your mortgage for several years. Note: you can refinance to a shorter term to avoid this. 
• Credit impact. Refinancing involves a hard credit inquiry, which can lower your credit score temporarily, and a new loan will reduce the average age of all your credit lines.

When to Refinance

Refinancing is generally favorable when interest rates drop, you’ve built significant home equity, or your credit score has improved, allowing for a lower rate or PMI removal. Major life events, such as income increases or debt changes may also make refinancing advantageous.

“Often, the best times to consider a refinance is when rates have dropped enough to make it worthwhile – usually by 0.5 to 1.0 percentage points,” recommends personal finance professional Andrew Lokenauth, an experienced mortgage/lending expert. “The timing can also be right if your credit score has improved a lot since your original mortgage and you have at least 20% equity built up in your home.”

Types of Mortgage Refinances

Refinancing comes in many different flavors that borrowers can choose from. Here’s a rundown of your options.

Rate and Term Refinance

A rate-and-term refinance focuses on lowering the interest rate, modifying the loan term, or both, aiming to reduce monthly payments or shorten the payoff period. With this option, you take no cash out at closing.

Cash-Out Refinance

A cash-out refi lets you borrow more than your mortgage balance, giving you the difference in cash at closing. This is a popular strategy for borrowers seeking to fund major expenses like a home improvement project, tuition, debt consolidation, business opportunity, or medical bills, but it reduces home equity and may require a slightly higher interest rate than a rate-and-term refinance.

Streamline Refinance

Streamline refinancing is available for government-backed loans, including FHA, USDA, and VA loans, and involves minimal paperwork and no need for an appraisal, making it a quick option to adjust interest rates or loan terms.

Renovation Refinance

“A renovation refinance lets you finance home improvement costs by using the property’s estimated future value after renovations are complete,” says Holman. “This is beneficial if you are looking to increase your home’s value through upgrades and prefer to roll the renovation costs into your mortgage instead of taking on separate financing.”

Cash-In Refinance

A cash-in refinance lets you pay down a portion of the principal when refinancing, which can help reduce the loan balance, secure a lower rate, or avoid PMI.

Short Refinance

In a short refinance, the lender agrees to settle for less than the amount owed, “effectively reducing the balance of the loan. This is often offered to borrowers facing financial hardship to prevent foreclosure, although it’s relatively rare and may impact your credit,” says Holman.

Debt Consolidation Refinance

A debt consolidation refinance allows borrowers to merge high-interest debts – including credit card balances – into their mortgage, thereby reducing monthly payments and simplifying finances.

Mortgage Refinance Programs

There are also different refi programs to be aware of that further differentiate your options. Let’s take a look at each.

Conventional Refinances

Designed for traditional home loans, a conventional refinance offers adjustments to the interest rate, term, or cash-out options and typically requires a good credit score and a manageable debt-to-income ratio.

FHA Refinances

FHA refinancing options cater to borrowers with lower credit scores or limited equity, offering several pathways to adjust their loan terms. Options include the FHA streamline refinance, the FHA cash-out refinance, and more.

USDA Refinances

Available for eligible rural homeowners, USDA refinancing includes streamlined paperwork and no appraisal requirement for qualifying borrowers. You cannot take cash out with a USDA refinance.

VA Refinances

VA refinance options, such as the Interest Rate Reduction Refinance Loan (IRRRL) and VA cash-out refinance, provide eligible veterans, military members, and surviving spouses with a streamlined process, minimal paperwork, and competitive rates.

How to Refinance Your Mortgage

Eager to get the refinance process started? Here are the usual steps involved, from beginning to end.

Shop Lenders

Start by gathering quotes from multiple lenders to compare rates, closing costs, and terms carefully. The more lenders you get rate quotes and offers from, the more likely it is that you’ll find the best deal. If you have a specific loan type in mind, such as a VA loan, be sure to look for lenders who specialize in this type of financing.

Run the Numbers & Check Eligibility

“Once you have a few offers, assess the potential savings by running the numbers,” advises Holman. “Consider the interest rate, monthly payments, and closing costs, and calculate how long it will take to break even on the costs of refinancing. Be sure to verify eligibility requirements, such as credit score, income, and equity.”

Apply

After choosing a lender, submit a formal application, which may require financial documents and, for some loans, a property appraisal. Then, you’ll await an underwriting decision.

Close Your Loan

After being approved, you’ll proceed to closing – where you will review and sign final loan documents. “This is also when closing costs are paid. Once the closing is complete, your new loan replaces the original mortgage and you will begin making payments based on the new terms,” continues Holman.

The Rules of Refinancing

To qualify for a refinance, you will generally need a solid credit score, steady income, and enough home equity to meet your lender’s requirements.

“Rules around refinancing – such as how often you can refinance or how soon after your initial loan you can refinance – will vary by lender and loan type,” Holman adds.

Truth is, you can refinance your mortgage as often as you qualify and can cover the closing costs. However, most loans require a waiting period between refinances, typically between 6 to 12 months, with additional specific rules for government-backed loans.

Before applying, it’s important to ensure you meet the standard eligibility requirements. Here’s a breakdown by loan type:

• Conventional loans: Generally, you’ll need a credit score of at least 620, a debt-to-income (DTI) ratio below 43%, and a loan-to-value (LTV) ratio no higher than 80% to secure the best rates and terms, according to Holman.
• FHA loans: The minimum credit score required is 580. For the best terms, aim for a DTI of 43% or lower and an LTV of 97.75% or less for rate-and-term refinancing and 80% for cash-out. FHA streamline refinances do not calculate DTI or LTV.
• VA loans: While the VA doesn’t set a specific credit score requirement, most lenders look for a score of 620 or higher. The ideal DTI is below 41%, and the LTV can go up to 100%. If you have a VA loan currently, there’s no DTI or LTV limit, since these loans don’t require an appraisal or income documentation.
• USDA Loans: USDA refinances are only available to homeowners with a USDA loan currently. These “USDA Streamline” loans typically do not require an appraisal. The lending limit is determined by the current loan size. 

Similar Options

Of course, a mortgage refi isn’t necessarily your only choice here. Alternative options to refinancing include:

• Mortgage recasting: With recasting, you make a lump-sum payment toward the principal, reducing monthly payments without changing your loan’s interest rate or term.
• Loan modification: Offered to those facing hardship, loan modification changes the terms of the existing loan and may impact credit, though it does not replace the loan.
• Second mortgage: A home equity loan provides access to home equity in a lump sum payout at closing without changing the primary mortgage, though it usually comes with a higher interest rate.
• Home equity line of credit (HELOC): Borrowing against home equity via a line of credit you can draw from at the time of your choosing to help fund major expenses more conveniently.

The Bottom Line

There are a lot of moving parts involved with a mortgage refinance. That’s why it’s important to do your homework ahead of time, check interest rates regularly, and understand your available options as well as the process from beginning to end and what’s required to qualify. Consult closely with a trusted loan advisor or mortgage professional who can guide you through every step along the way.