Refinancing Your Home Loan

The Truth About Refinancing Your Mortgage

If you have a mortgage, you don't necessarily have to make payments on the same loan for 15 or 30 years -- you could refinance your loan somewhere along the way. However, refinancing isn't well understood by many U.S. homeowners, so here's a look at how refinancing a mortgage works and how to refinance a mortgage if you think it might be a good move for you.

What does it mean to refinance a mortgage?

In the financial world, the term refinancing means using a new loan to replace an existing one. So, refinancing a mortgage means obtaining a brand-new mortgage to replace your current one.

There are several reasons people refinance their mortgages, which we'll get into in detail later. But for the time being, know that refinances are generally done to improve the terms on your mortgage, to save money on interest by getting a lower mortgage rate, to cash out some of your home equity, or a combination of the three.

How does refinancing a mortgage work?

The process of refinancing a mortgage works in a similar way to obtaining a mortgage to purchase a home, with the obvious difference being that you already own the home. You'll need to contact a lender, fill out a mortgage application for a refinancing loan, and go through the lender's approval process.

There are two main qualification requirements for refinancing your mortgage. First, your personal credit and income qualifications must be sufficient to justify the mortgage. Borrowers with top-notch credit scores tend to get the best interest rates on refinancing loans, just as they would with a purchase mortgage. Lenders also want to see that the borrower's income is sufficient to comfortably handle the loan payments, and that they have a stable employment situation, which typically means at least two years of steady work in the same field. Most lenders also verify a borrower's assets. It's common for them to look for a certain number of monthly payments in readily available reserves.

As for the second requirement: Your home's value and the amount you want to borrow must make good financial sense to the lender. In most (but not all) cases, lenders want to see that the new loan will produce a maximum loan-to-value, or LTV, ratio of 80%. For example, if your home's appraised value is $200,000, most lenders will refinance a maximum of $160,000.

There are some exceptions, however. Refinancing loans with an LTV of as high as 90% or even higher aren't uncommon, but the borrower will typically need to have top-notch qualifications in order to obtain a refinancing loan like this.

Finally, it's important to point out that refinancing a mortgage is not free. Refinancing loans typically involve closing expenses, such as underwriting and origination fees, just as there would be with a purchase mortgage. Some of our favorite mortgage lenders for refinancing have below-average fees, but refinancing is still likely to cost you something.

Types of refinancing

There are several types of refinancing loans, but most fall into these broad categories:

• Rate and/or term refinancing: This is what I would refer to as "standard" refinancing. Essentially, this involves replacing your existing mortgage with another for the same principal amount, with the goal of lowering your interest rate, changing your loan term length, or both.

• FHA refinancing: FHA mortgages can be excellent tools to open the door to homeownership but aren't great loan products after the homeowner has built up significant equity. There are streamlined FHA mortgage refinancing programs designed to quickly and easily refinance these loans for borrowers who would benefit from such a move.

• Cash-out refinancing: Another type of refinancing loan allows homeowners to take cash out of their property's equity. For example, let's say that your house is worth $300,000 and you owe $150,000 on your current mortgage. You could obtain a $200,000 refinancing loan and get $50,000 in cash at closing, which you could then use to fund home improvements or any other purchase you're looking to make.

• HELOC: HELOC stands for home equity line of credit, and although it's not technically a form of home refinancing, it is similar in nature to cash-out refinancing and is worth mentioning. Essentially, a lender gives you a credit line based on your home equity, which you could choose to use or not as you see fit. The biggest difference between a HELOC and cash-out refinance is that you're not making any changes to your existing mortgage.

When is it a good idea to refinance?

There are a few reasons it might be a good time to refinance your mortgage, and here are seven of the most common:

• Lower your interest rate: If current mortgage interest rates are significantly lower than the rate you're paying at the moment, refinancing your mortgage could save you significant money in the long run. For example, replacing a $250,000 30-year fixed-rate mortgage at 5% interest with one at 4% interest could save you more than $4,000 over the life of the loan. But one word of caution: Refinancing typically costs a significant amount of money in lender fees and other closing costs. Be sure that you're going to live in the home long enough for the cost savings to justify any upfront fees.

• Get cash: Refinancing your mortgage can be a great way to get cash to finance a big purchase, such as a home renovation project. If you have significant equity in your house, you can use a refinancing loan to pull some of your equity out -- and at a lower interest rate than you may be able to find otherwise.

• Lower your monthly payment: If you refinance your mortgage at a lower interest rate than your current loan, and/or extend your repayment term, you can reduce your monthly payment obligation. If you're trying to reduce your expenses, refinancing your mortgage can allow you to do just that.

• Shorten your repayment term: If you aren't necessarily worried about the amount of your monthly payment, you could potentially refinance into a shorter-term loan and save thousands in interest while repaying your mortgage faster. For example, let's say that you have 28 years left on a 30-year fixed-rate mortgage at 5% interest with $250,000 remaining on the principle. If you can refinance your balance into a 20-year mortgage at 3.25%, your monthly payment would rise by less than $50 per month and you'd pay off your loan eight years sooner.

• Get a fixed interest rate: One of the smartest moves you can make if you have an adjustable-rate mortgage, or ARM, is to refinance it into a fixed-rate loan while interest rates are low. In virtually all cases, locking in a historically low interest rate for the term of the loan is preferable to the uncertainty of a rate that changes over time.

• Get rid of FHA mortgage insurance: With a conventional mortgage, if you have private mortgage insurance (PMI), you can easily get rid of it once your loan-to-value (LTV) ratio falls below 80%. On the other hand, mortgage insurance on an FHA loan generally cannot be canceled. However, you can potentially get rid of FHA mortgage insurance by refinancing into a new mortgage.

• Combining multiple payments: If you have a mortgage, a home equity loan or line of credit, and/or some other types of debts, a refinancing loan can allow you to consolidate them into one monthly payment.

How soon can you refinance a mortgage?

The short answer is that you can refinance your mortgage as soon as you want. If you obtained a 30-year mortgage at 5% interest and rates plummet to under 4% within a couple of months, it could certainly be a great idea to refinance your loan.

Having said that, some lenders might have restrictions. It's not uncommon for lenders to require a six-month period to pass before obtaining another mortgage on the property with the same lender. However, you can still shop around and see if you can refinance through another lender if doing so would be a smart financial move.

What documents do I need to refinance?

As mentioned, mortgage refinancing is based on two main factors -- your personal credit qualifications and your home's value. Your lender will typically take care of the latter by ordering an appraisal.

However, you'll likely need to provide some documentation during the process. This can include, but is not necessarily limited to:

• Identification: This typically means your driver's license or other government-issued photo ID with your date of birth, as well as your Social Security card. A valid U.S. passport is also an acceptable form of identification.

• Income documents: Just like when you get a purchase mortgage, a refinancing lender will want to see that you earn enough to pay your bills, and that you have a stable employment history. Be prepared to produce W-2s, 1099s, your last couple tax returns, and some recent pay stubs.

• Asset documentation: Your lender will probably want to see your recent bank statements, brokerage and retirement account statements, and any other substantial assets you own.

• Your debts and credit history: Your lender will order a credit report from all three major credit bureaus, and you may have to disclose and document any significant debts that aren't included on your credit file.

• Explanation letters: If there's anything that could trigger a red flag for your lender, be prepared to have an explanation for it. Examples of things you may need to provide written explanations for include gaps in employment, any debts that you plan to pay off before closing, any debts that you plan to pay off with funds from closing (cash-out refinances), any adverse credit information, and any recent credit applications for loans other than a mortgage.

• Insurance information: Your lender will want to see that your home is adequately insured before lending money on it. Be prepared to provide a copy of your current homeowners insurance policy.

How to refinance a mortgage step by step

To sum it up, here's the process of refinancing your mortgage:

1. Decide if refinancing is right for you: The first step in the process is deciding if you should refinance your mortgage. If you have a low interest rate, don't need to take out any cash, and can comfortably handle your payments, refinancing might not make good financial sense.

2. Get your documentation in order: Because you'll need to qualify for a refinancing loan just like you would for a purchase mortgage, you'll need to be able to document your income, assets, and identification. Refer to the previous section on documentation and gather the necessary items before you apply. (Note: I'm telling you to do this before you apply so that if you're missing anything -- say, a copy of your 2019 W-2 -- you can track it down before a lender asks for it.)

3. Shop around for the best rate: Here's one of the most important and often overlooked parts of refinancing. You should fill out pre-approval applications with at least a few of the best mortgage lenders to compare rates and fees. You might be surprised at how different the terms can be from lender to lender, and this extra effort could save you thousands over the term of the loan.

4. Apply for the best refinancing loan for you: Once you've done some rate shopping, it's time to apply for the refinancing loan that makes the most sense for you. The lender will walk you through the process of submitting documentation and will let you know anything else you need to do.

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