What Is A Refinance And How Does It Work?
Sidney Richardson9-minute read
February 19, 2022
When you buy a home, you typically take out a mortgage loan to finance it, unless you made an all-cash offer or obtained the house through other circumstances. When you’re in the process of paying off that mortgage loan, there will be times you may wish you could alter its terms. If you get divorced, as an example, you may need to remove a spouse’s name from the title. Interest rates could also drop, leaving you wishing you had gotten your mortgage at a lower rate.
You can actually make these changes happen by getting a mortgage refinance. But what exactly is a refinance, and how does it work? Let’s break down what a refinance is, how to get one and how it could help you.
What Is Refinancing A Mortgage?
A refinance is a process that allows you to replace your current mortgage loan with a new one, typically one that has better terms. Your lender uses this new loan to pay off the old one, so you will still only have one payment to take care of each month.
People typically refinance their mortgages for a number of reasons. You could lower your monthly mortgage payments. If you can secure an interest rate lower than the one you originally got your loan at, you might also be able to save yourself thousands of dollars in interest over the life of your loan.
Beyond saving money, you might also refinance to solve a problem. If you got divorced from a partner that is still on the title to your house, you might refinance to remove their name. If you need to make large-scale renovations to your home, you can also refinance to take money out of your home equity to fund a home improvement project.
How To Refinance A Mortgage
So, how do you go about refinancing a mortgage? Whether you want to refinance for a lower rate or cash out some equity, you’ll need to follow the same initial steps.
- Just like getting a loan to purchase a house, you’ll have to apply for your refinance. That means you’ll want to make sure your credit score is as high as possible and that you pay down as much of your debt as you can.
- If you want to take cash out of your current loan’s built-up home equity, you should also make sure ahead of time that you have enough to withdraw for the purpose you’ll need it for. We’ll talk about cash-out refinances more in depth later.
- Once you’ve got your credit, debt-to-income ratio (DTI) and other factors in good shape, you’ll want to shop around for mortgage lenders. Get multiple quotes from different lenders to see what refinance rate offers are available to you. You want to make sure you get the interest rate and loan term that will be most beneficial to you – refinancing to pay more for your home loan than you were before doesn’t make much sense.
- Finally, once you’ve settled on the offer you’re most comfortable with, you’ll submit an application. The refinance application process is very similar to purchasing a home: you’ll lock in your interest rate, get an appraisal and close on the loan almost the same way as you did the first time.
When Should You Refinance?
There’s no legal limit on how many times you can refinance your home loan. If you wanted to, you could technically refinance every 6 months or potentially even more often, depending on your lender’s requirements. It’s not likely that this strategy would help you much, though – and it would put a serious drain on your savings to close on a loan over and over again.
So, when is the best time to refinance? There’s no one-size-fits-all answer, unfortunately. The best time to refinance will depend largely on why you want to do so. Here are a few examples of situations where you might consider refinancing:
- When rates are dropping, and you can secure a lower rate to help you save on interest
- If your credit is significantly better than when you got your loan, you could refinance for a better rate
- If you want to pay off your loan faster, you could change the loan terms (30-year fixed to 15-year fixed, etc.)
- If you want to change your loan type (from an adjustable-rate mortgage to a fixed rate, etc.)
- When you want to remove someone’s name from the title
- When you need cash for a home improvement project or to consolidate debt
Different Types Of Refinance
When you refinance a loan, there are a few different ways you can go about it, depending on why you’re refinancing. Let’s go over a few different types of refinance.
Rate And Term Refinance
A rate and term refinance is a type of refinance that allows you to change the terms of your previous loan to ones that are more favorable to you. You would typically do a rate and term refinance to lower your interest rate, monthly payment or shorten your repayment term. This may include getting a lower interest rate or changing the term of your loan from 30 years to 15.
When you make your monthly mortgage payments, you build equity in your house over time. A cash-out refinance is a type of refinance that allows you to “withdraw” some money from your home equity to use for another purpose. Should you need money to renovate your home or pay for another important circumstance, a cash-out refinance allows you to borrow from your investment.
When you cash out equity, you receive the difference between your mortgage balance and the appraised value in the form of cash. For instance, you may owe $225,000 and you refinance for $300,000. In that case, you’d receive $75,000 in cash that you can use for whatever you need – from funding a child’s college education to putting in a brand-new kitchen.
It’s nice to be able to get some use out of your biggest investment, but the downside of a cash-out refinance is that you’ll be making payments longer in addition to paying more in interest if you’re stretching out the term of the loan.
A “consolidation refinance” is not its own type of refinance, but rather a specific usage of a cash-out refinance. If you have a lot of high-interest debt, such as credit card debt, you can use a cash-out refinance to pay off all these debts and “consolidate” the debt into your mortgage, which has a lower interest rate. By doing this, you’re essentially lumping all your debts into one payment with a more beneficial interest rate.
Home Refinance Options
Depending on who your mortgage loan is backed by or purchased by, there may be different options as well as things you have to consider when you refinance. Let’s go through some of the differences briefly.
Conventional Loan Refinance
A conventional loan is a loan that meets the requirements of Freddie Mac and Fannie Mae, the government-sponsored enterprises that purchase mortgage loans and sell them to investors. To refinance a conventional loan, you typically need a minimum FICO® Score of 620 and a maximum DTI of 65%. There may be additional requirements on how large or small your refinanced loan can be based on your county’s loan limit.
Conventional loan refinances allow you to lower your interest rate or change your term if you have as little as 3% – 5% existing equity for a one-unit primary property. If you have more units, the amount of equity necessary will be higher.
You can take cash out as well. On a one-unit primary property, you can generally convert your existing equity to cash as long as you leave 20% equity in the home. If you have more units, a second home or an investment property, you may need to leave more existing equity in the property.
FHA Streamline Refinance
An FHA loan is a mortgage that is backed by the Federal Housing Administration (FHA) rather than purchased by Freddie Mac or Fannie Mae. An FHA Streamline Refinance is a product offered by the FHA that allows you to quickly refinance an FHA loan to a lower interest rate and lower monthly payment.
To refinance an FHA loan on a primary residence, you’ll generally need a minimum credit score of 580 – 620, depending on your lender. The maximum DTI ratio you can have will depend on what state your home is in.
There are also two “types” of streamline refinance: credit qualifying and non-credit qualifying. Credit-qualifying basically just means you will provide income documentation and your lender will perform a credit check. With a nonqualifying refinance, your lender will still look at your credit, but there will be fewer factors your lender will consider within your report. For a nonqualifying refinance, your lender may not even need to verify your income; instead, they’ll use your existing loan as a “template” to understand your financial profile. This simplifies the approval process and may speed up your closing.
A VA loan is a loan backed by the U.S. Department of Veterans Affairs (VA) and is offered to qualifying veterans, active service members and surviving spouses. VA loans have a few different refinancing options. You could qualify for a VA Interest Rate Reduction Refinance Loan (VA IRRRL), which allows you to potentially reduce your interest rate as well as roll your closing costs and fees into your mortgage rather than paying upfront.
You could also do a VA cash-out refinance, which works similarly to a regular conventional cash-out refi. Unlike a conventional refinance, a VA cash-out may allow you to withdraw all your equity without leaving 10%-20%, though some lenders may require that you have a certain minimum credit score to do this. The VA itself does not set a minimum credit score.
To qualify for a VA refinance, you’ll need your Certificate of Eligibility, and you’ll have to meet your lender’s income and credit requirements. The home you’re refinancing a loan for must also be your primary residence.
USDA Rate/Term Refinance
A USDA loan is a mortgage backed by the U.S. Department of Agriculture. These loans are intended to help people that live in rural areas achieve homeownership at a reasonable cost. Rocket Mortgage® does not currently offer USDA loans.
USDA loans allow you to do rate and term refinances, but not cash-out. The USDA has a Streamline Refinance program similar to the FHA that allows borrowers to refinance quickly with little to no equity required and no mandatory appraisal. The USDA also doesn’t set a minimum qualifying credit score, so it’s up to the lender to determine a minimum if they choose to.
Pros And Cons Of Refinancing
Refinancing can help you lower your monthly payments and turn the terms of your loan in your favor, but these perks don’t come without a cost. Let’s talk about the pros and cons of refinancing your mortgage loan.
- Lower your monthly payments. Refinancing can help you lower your monthly mortgage payments and save some money.
- Save on mortgage interest. If you manage to secure a lower rate, you could save thousands of dollars you would have otherwise paid in interest over the life of your loan.
- Consolidate your debt. If you have a lot of high-interest rate debt, a cash-out refinance can help you put all that debt in one place with a lower interest rate so it’s not so overwhelming.
- Remote private mortgage insurance (PMI). If your new refinanced mortgage balance is below 80% of the home’s value, you likely won’t have to pay PMI anymore on a conventional loan.
- You’re essentially restarting from square one. When you refinance, in terms of how much of your monthly payments go toward paying interest, you’ll be starting over. This means you might pay more interest overall by refinancing. You can use an amortization calculator to help determine whether your new loan will actually save you money in the long run.
- You have to pay closing costs. Just like purchasing a house, when you refinance a home loan, you have to pay closings costs, which are around 3% – 6% of your total loan amount. If your new loan is for $250,000, that’s $7,500 – $15,000 you’ll likely have to pay upfront.
- Your savings might not be substantial. When you refinance, your savings aren’t guaranteed. If rates haven’t dropped much since you got your loan – or if your credit has remained stagnant or even gotten worse – you may not stand to save much by refinancing.
- It won’t happen instantly. Just like getting a mortgage for the first time, refinancing takes time. If you’re trying to get a cash-out refinance in order to pay for an urgent expense, be aware it could take anywhere from 30 – 45 days or longer to get through the process.
The Bottom Line
Refinancing your mortgage is a great way to lower your monthly payment, save on interest or even get some much-needed cash for home improvement. It’s not always the right choice, however, so be sure to consult a financial professional to help you determine whether it could be a good option for you.
Want to learn more about refinancing and other mortgage-related topics? Check out our Home Buying Guide for tips, tricks and resources to help you on your homeownership journey.
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