Refinancing Your Mortgage: How it Works & When it’s Right for You
We've demystified how refinancing works
Are you looking to reduce your monthly mortgage payments, get a lower interest rate, convert your home equity into cash, or switch to a fixed-rate loan? Consider refinancing your home loan.
However, before you decide to refinance it's important to understand how the process works and to evaluate the pros and cons for your individual situation. For example, many homeowners are surprised at the amount of documentation needed to get approved and aren't aware that there are some refinance options requiring very little paperwork.
Learning the basics of home refinancing—and how it contributes to your goals—will help you decide which mortgage option makes the most sense for you.
What are some good reasons to refinance your mortgage?
- Lower your payment
- Use your home equity to better manage debt
- Pay off your loan faster
- Get a low rate for the life of your loan
What Is Refinancing?
Refinancing is the process of replacing an existing mortgage with a new loan. Typically, people refinance their mortgage in order to reduce their monthly payments, lower their interest rate, or change their loan program from an adjustable rate mortgage (ARM) to a fixed-rate mortgage. Additionally, some people need access to cash in order to fund home renovation projects or paying off various debts, and will leverage the equity in their house to obtain a cash-out refinance.
Regardless of your goal, the actual process of refinancing works much in the same way as when you applied for your first mortgage: you'll need to take the time to research your loan options, collect the right financial documents and submit a mortgage refinancing application before you can be approved.
What Is the Process for Refinancing Mortgage Loans?
How does refinancing work? Although it’s usually less complicated and time consuming than the initial home buying process, refinancing your mortgage still follows a similar set of steps:
During the refinancing application process, your first step should be to determine what type of refinancing will best fit your needs. Once you’ve made your decision, you will need to provide your lender with documentation relevant to your loan, including paystubs, W2s and bank statements. Your lender will also use information related to your assets, income and credit score to determine the risk associated with offering you a loan. If you meet the loan requirements, the application can go through.
Mortgage Rate Lock Option
Mortgage interest rates are extremely dynamic, and may change from day to day. After finalizing your application and getting approved for your loan, your lender may give you the option to lock your rates so they don’t change before you close on the loan. Typically, you’ll have the option to lock your rates for a period of 30, 45 or 60 days, with the option to extend the rate-lock period for additional fees. Alternatively, you may choose to ‘float’ your rate rather than locking it in, accepting whatever mortgage rates may be at the time of closing.
With your application submitted and your rates locked-in or floating, the lender must then review and verify your information. This underwriting process will also include a home appraisal, where a licensed appraiser will visit your property to create an estimate of its current value. The value of your property will help determine the limit of your loan. We recommend having a list on hand with any upgrades you may have made to the property during homeownership.
The final stage in the process is to close on the new loan. The lender will create and share with you a Closing Disclosure (CD) document detailing the important information and costs relevant to the loan. This includes loan fees, real estate taxes, the amount financed, annual interest percentage rate, finance charge and payment schedule. When you close, you will meet with the lender to go over the details, sign the loan documents and settle on any additional costs that are not included in the closing costs. Although closing may feel final, you will still have a short, three-day grace period after closing during which you can back out of the refinance if you need to.
Reasons to Refinance
There are several reasons to refinance your mortgage. Some of the potential advantages include:
- Lowering your monthly payment*. According to one study, an average homeowner may save $160 or more per month with a refinance. With a lower monthly payment, you are free to put the savings toward other debts and other expenditures, or apply that savings towards your monthly mortgage payment and pay off your loan sooner.
- Remove private mortgage insurance (PMI). Some homeowners who have enough property appreciation or principal paid off will not be required to pay mortgage insurance which will reduce your total monthly payment.
- Reducing the length of your loan. For homeowners who took out a mortgage in the early stages of their career, a 30-year mortgage may have made the most financial sense. But for those who want to pay off their mortgage sooner, reducing the loan term can be an attractive option.
- Switching from an adjustable-rate mortgage to a fixed-rate loan. When you have an adjustable-rate mortgage, your payment can adjust up or down as interest rates change. Switching to a fixed-rate loan with reliable and stable monthly payments can give homeowners the security of knowing that their payment will never change.
- Consolidating your first mortgage and your home equity line of credit (HELOC). By rolling these into a single monthly payment, you can simplify your finances and focus on one debt. HELOCs often have adjustable rates, so refinancing into a fixed-rate loan could potentially save you money in the long run.
- Using the equity in your home to take out cash. With rising home values, you may have enough equity to take out a cash-out refinance. This money can be used to finance home improvements, pay off debts or to fund large purchases.
Risks of Loan Refinancing
Depending on your goals and financial situation, refinancing mortgage loans may not always be your best option. While refinancing offers many benefits, you’ll also have to weigh the risks.
For example, refinancing your mortgage usually restarts the amortization process. So, if you are five years into paying on a 30-year loan and you decide to take out a new 30-year mortgage, you’ll be making mortgage payments for 35 years. This is a good plan for some homeowners, but if you’re already 10 or 20 years into your mortgage, then the lifetime interest may not be worth the extra costs. In these instances, many homeowners refinance into a shorter-term loan that won’t extend the time they will make mortgage payments, such as a 20 or 15 year mortgage (which oftentimes offer lower rates than 30-year loans).
Generally, refinancing is a good option if the new interest rate is lower than the interest rate on your current mortgage, and the total savings amount outweighs the cost to refinance. For example, if you have $390,000 remaining on a $400,000 loan at 4.25%, replacing your existing mortgage at 3.75% can earn savings of $162 per month compared to your previous loan.*
Use our mortgage calculators to estimate what your new monthly mortgage payments might be.
*By refinancing your existing loan, your total finance charges may be higher over the life of the loan.
Frequently Asked Refinancing Questions
Before you choose to refinance, it’s important to be prepared. To gauge your refinancing readiness, consider the following questions.
Should I Refinance if I Only Plan on Living in My Home for a Few More Years?
Similar to when you initially purchased your home, you will have to pay fees, taxes and closing costs on your refinance mortgage. It is important to determine how long it will take to reach your “break-even point” when refinancing a mortgage. The break-even point is the point at which the monthly savings created by a mortgage refinance offsets the cost of refinancing.
Per the Consumer Financial Protection Bureau, you should consider how long it will take for the monthly savings to pay for the cost of the refinance. Review the closing costs you paid for your original loan to purchase the home. Refinancing costs can be about the same amount. A common rule of thumb is to proceed only if the new interest rate saves you that amount over about two years (in other words, if you break even in about two years).
So, make sure you do the math and understand how the new loan will affect you.
How Does My Credit Score Affect Refinancing?
Your credit score not only helps determine your mortgage refinance approval, but also determines the interest rate your lender is going to offer. Simply put, the higher your credit score, the lower your interest rate is going to be.
For example, a borrower with an average loan size of $250,000 and a credit score of 640 may pay around $2,500 more a year in interest payments than a borrower with a credit score of 760. If your credit score has fallen since you first obtained your mortgage, you can expect to pay higher rates—which may negate any potential benefit of refinancing.
What’s My Remaining Loan Balance?
Before signing a new mortgage, you’ll need to assess your current loan balance. If you’re currently on the 15th year of your 30-year loan, you may want to look at your options for refinancing with a shorter term. This makes sense for a lot of homeowners because it allows them to take advantage of historically low rates without pushing out their payoff date, which can often provide substantial savings.*
Do I Need Flexibility or a Rigid Payment Schedule?
A common use for refinancing is to shorten the length of a loan and pay it off earlier. If current mortgage interest rates are lower than your current interest rate, it’s common to have a similar monthly payment amount while shaving years off your mortgage.
For example, homeowners with a 30-year mortgage may refinance into a 15-year loan. This can be a great choice, but there are things to consider:
First, most banks and other lenders will allow you to pay off your mortgage early. So, if you want to pay off your 30-year loan in 15 years by making extra payments, you may be able to do so. This can help you build equity faster and save on interest payments. If circumstances change and times get tough, you have the freedom to revert to the original contractual 30-year payment.
On the other hand, a 15-year loan typically offers even greater interest savings, and can also help you build equity quickly—so you can own your home free and clear sooner rather than later.
Is Refinancing Available for FHA, VA, Jumbo, or USDA loans?
Yes, depending on your current situation, one of these options might make sense for you. Also, if you currently have a Conventional, FHA, VA, Jumbo, or USDA loan, there are options available including several streamline refinance programs. Streamline refinance programs offer a simplified approval process by reducing or eliminating many of the income, credit or appraisal reviews that are included in standard refinance programs. The VA streamline program is called the Interest Rate Reduction Refinance, or “IRRRL”. It’s important to mention that streamline refinance loans may not allow a cash-out option. Also, like other refinancing options, streamline refinance loans may increase your total cost over the life of the loan.
Is Now the Right Time to Refinance?
Ultimately, it’s critical to crunch the numbers to see if refinancing makes sense for you. Even if you’ve been unable to refinance in the past, loan programs and rates are always changing. These changes, along with rising home values in several markets, may enable you to reduce your rate or lower your monthly payments.
But you don’t have to go at it alone! Pennymac Loan Officers are always ready to answer your questions and guide you along the path to a successful refinancing.
Resources & Tools
A 15-year mortgage is just one option you have as a homebuyer. Learn the benefits and drawbacks and decide if it’s right for you.
You may have heard that you should refinance to lower your interest rate or shorten your loan term, but are those the only reasons?