How Does Refinancing a Mortgage Work? A Homeowner Planning Guide

What does it mean to refinance your house?

Refinancing your house means replacing your existing mortgage with a new loan, usually to get different loan terms or a new interest rate. Many homeowners refinance to lower their monthly payment, pay off their loan faster, or borrow against their home equity for a major expense. Think of it as swapping out your existing mortgage for one that better fits your current financial goals.

There are plenty of reasons people choose to refinance. Some want to take advantage of lower rates, while others plan to switch from an adjustable-rate mortgage to a fixed-rate loan (or vice versa). It can be a smart way to save money or gain more financial flexibility, but it’s still important to weigh the potential benefits against the costs involved.

“Factors to consider: Is there a need? Buying a home is obvious: I have to have somewhere to live. Needs to refinance are different,” says Hammond. “A true need would be, ‘I can’t afford my payment. I have to get it lower.’ Another true need would be, ‘I need cash to address something,’ whether it’s a renovation project or a large obligation like a medical bill or tax situation.”

How does refinancing work?

Refinancing a mortgage involves many of the same steps you went through when you first bought your home. While the process may feel familiar, the goal is different: you’re replacing your current loan with a new one that better fits your needs. Here’s a simple breakdown of how mortgage refinancing works:

1. Assess your financial goals: Before diving into refinancing, it’s important to know why you’re doing it. Are you looking to lower your monthly payments, shorten your loan term, or get cash from your home equity? Your goals will guide the refinancing process.
2. Check your credit score and history: Your credit score plays a big role in the interest rates and loan terms you may qualify for. Before applying, take a look at your credit report, make sure the information is accurate, and fix any errors you find. A stronger credit profile can improve your chances of landing a better refinancing deal.
3. Understand your home’s equity: Know how much of your home you actually own. That home equity matters when it comes to whether you can refinance and what kind of terms you’ll get.
4. Shop around for the best rates: Don’t settle for the first offer. Compare rates and terms from different lenders to find the best deal for your situation.
5. Get your documents in order: Prepare the necessary financial documents. These typically include recent pay stubs, tax returns, and bank statements, among others.
6. Apply for refinancing: Once you’ve found a suitable lender, fill out an application. Be prepared for a thorough review of your financial situation.
7. Go through the home appraisal process: Lenders will require an appraisal to determine the current value of your home. This impacts how much you can refinance.
8. Close on the new loan: If approved, you’ll go through a closing process similar to when you first obtained your original mortgage. This will involve signing a host of documents and possibly paying closing costs.
9. Start paying your new mortgage: After closing, you’ll start making payments on your new loan, now adjusted according to your refinanced terms.

While refinancing can be beneficial, Hammond says it’s important to consider the entire picture, including costs and potential savings, to ensure it aligns with your financial goals. In addition, there are different types of refinancing options available.

What are the different types of mortgage refinancing?

Homeowners have various refinancing options, each serving different financial needs and situations. These options can be grouped into more common and less common types.

How refinancing can play out: two example scenarios

Traditional rate-and-term refinance example: Imagine Sarah and John bought their home with a 30-year fixed-rate mortgage at a 6% interest rate. Their monthly mortgage payment was $1,200. When rates went down, they refinanced at a 4% interest rate.

By refinancing to the lower rate while keeping the same loan term, their new monthly payment dropped to approximately $1,000, saving them $200 per month. Over the remaining 25 years of their mortgage, this adds up to significant savings.

Cash-out refinance example: Consider Emily, a homeowner with a remaining mortgage balance of $200,000. Her home’s current market value is $400,000, giving her substantial equity. Looking to renovate her home and consolidate high-interest debt, Emily opts for a cash-out refinance. She decides to cash out $82,000.

This increases her total mortgage balance to $282,000. With this refinancing, Emily’s monthly payment increases by approximately $150. However, she now has the funds for her home renovation and debt consolidation.

»Learn more: After seeing how refinancing can lower payments or free up cash in different scenarios, it’s a good time to zoom out and check what home price actually fits your updated budget. Use the Home Affordability Calculator below to plug in your new numbers so you can house hunt with a clearer, more realistic range.

Why homeowners choose to refinance

As mentioned, many homeowners don’t always keep the same mortgage for the entire life of their loan. As financial situations shift and market conditions change, many begin to take a closer look at whether their current loan still makes sense. Here are some of the most common reasons homeowners decide to make a change:

• Lower interest rates: One of the most common reasons people refinance is to lock in a lower interest rate, which can bring down monthly payments and cut down how much interest you pay over the life of the loan.
• Shorten loan term: Refinancing can allow homeowners to switch from a 30-year to a 15-year mortgage, for example. This can lead to paying off the loan faster and saving on interest, despite a potential increase in monthly payments.
• Convert between adjustable-rate and fixed-rate mortgages: Homeowners might refinance to switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage for more predictable payments, or vice versa for lower initial rates.
• Cash out equity: As seen in the cash-out refinance example, homeowners can tap into their home equity to cover large expenses, such as home renovations or debt consolidation.
• Remove private mortgage insurance (PMI): If a home’s value has increased, refinancing can help homeowners reach 20% equity, allowing them to eliminate PMI and lower their monthly expenses.
• Bundle debts into one loan: By consolidating high-interest debts into a mortgage with a lower interest rate, homeowners can make their finances a lot easier to manage.

What are the drawbacks of refinancing your mortgage?

Refinancing can be a helpful move, but it’s not always the right fit for every situation. Like any financial decision, it comes with trade-offs that are worth understanding upfront. Before making a change, it’s important to look at the potential downsides as well as the benefits.

• Closing costs: Refinancing a mortgage comes with closing costs that can add up, and in some cases, they may eat into or even outweigh the savings from a lower interest rate.
• Longer loan term: If you refinance into a new 30-year loan, for instance, you could end up paying more in interest over the life of the loan, even if your monthly payments are lower.
• Potential for higher payments: If you opt for a cash-out refinance, your overall loan balance increases, which could lead to higher monthly payments.
• Foreclosure risk: By refinancing, you’re essentially taking out a new mortgage. If you fail to make payments, you risk foreclosure, just as with your original mortgage.
• Lost benefits: Some original mortgages might have special features like federal loan forgiveness that could be forfeited upon refinancing.
• Credit score impact: Refinancing can temporarily impact your credit score due to the lender’s credit inquiry and the closing of the old mortgage account.
• Borrower’s remorse: If interest rates drop substantially after you close on your refinance, you might have regrets about the timing and costs.
• Interest rate risk: For those switching to an adjustable-rate mortgage, there’s the risk of interest rates increasing in the future, which could raise monthly payments.

How much does it cost to refinance a mortgage?

Refinancing a mortgage typically costs between 2% and 5% of the loan amount. This means refinancing a $200,000 loan might cost between $4,000 and $10,000. These costs include application fees, appraisal fees, title searches, and closing costs.

Hammond reiterates that it’s important to consider the overall price of refinancing. “Don’t get caught up in interest rates.”

If you’re planning to move within the next year or two, the costs of refinancing may actually cause you to lose money. Similarly, if your loan balance is relatively low, you may be better off sticking with your current mortgage.

“If I have a $100,000 loan balance and I can reduce my rate by 1%, that sounds like a lot, but in terms of real dollars, it won’t reduce the payment by much,” says Hammond, who warns that a portion of the costs associated with refinancing are flat-rate and independent of the loan size.

“If an appraisal costs $425 and a closing attorney costs $495, I’m paying those amounts regardless of whether I’m refinancing $100,000 or $500,000. The dollar for dollar [on these costs] is the exact same, but saving 1% interest on $500,000 is far more substantial.”

Hammond encourages homeowners to talk through the process with a trusted lender and put a plan together that finds the most efficient use of their time and money.

A 1% rate drop may not be worth it

“I hear people say all the time, ‘I’ve got to reduce my rate by 1% for it to be worth it,’ and, well, that’s bogus,” says Hammond. “I don’t talk about refinancing in terms of the interest rate. I talk about it in terms of the cost-benefit. You want to consider the change in the dollar amount coming in or going out each month, in relation to the cost of getting there.”

The same rationale applies if you’re looking to shorten your loan term, remove mortgage insurance, or take out cash from the equity in your property.

“The refinance transaction where you only drop your interest rate by a quarter of a point, but you also eliminate your monthly mortgage insurance? That’s a transaction you do all day long,” says Hammond. “That’s going to be a huge dollar figure in terms of savings.”

If you’re looking to shorten your loan, say, refinancing from a 30-year mortgage to a 15-year mortgage, your monthly payment may increase while your interest rate goes down, allowing you to pay down the loan principal faster if you’ll be in the house long enough for the numbers to make sense.

What documents are needed to refinance a mortgage?

Refinancing a mortgage means your lender is going to take a close look at your finances all over again, so you’ll need to pull together a bunch of documents. It might feel a little repetitive if you’ve done it before, but it’s just to make sure you still qualify for the new loan.

Most lenders want proof of income, assets, and your overall financial stability. Having everything ready upfront can make the whole process way smoother and faster. Here’s what you need to prepare:

Questions to ask yourself to know if refinancing is right for you

Deciding to refinance your mortgage is a significant financial decision. “It’s not a good idea or a bad idea,” says Hammond. “It’s an idea to be discussed. You hash it out and let the numbers tell you what makes the most sense.”

To determine if it’s the right choice for your situation, ask yourself these questions:

• Will refinancing lower my rate or payments enough to justify the costs? Consider if the savings from refinancing outweigh the closing costs and fees involved.
• How long do I plan to stay in my home? If you plan to move soon, you may not stay long enough to recoup the costs of refinancing.
• What are my financial goals? Are you looking to reduce monthly payments, pay off your mortgage faster, or use your home equity for large expenses?
• How will refinancing affect my overall financial plan? Think about how changing your mortgage terms fits into your broader financial strategy.
• Am I prepared for the potential impact on my credit score? While usually temporary, refinancing can affect your credit, so consider the timing if you have other major credit applications planned.

Should you refinance your mortgage?

Refinancing can offer significant financial benefits, but it isn’t a one-size-fits-all solution. Depending on your interest rate, loan balance, credit profile, and how long you plan to stay in your home, the savings can vary widely. In some cases, the upfront costs of refinancing may reduce or delay the financial benefits.

Each homeowner’s financial situation, goals, and timeline are different, which makes the decision highly personal. That’s why it’s important to take a closer look at how a refinance would actually impact your monthly budget and long-term plans. Consider consulting a financial advisor to help you evaluate the numbers and make a decision that fits your specific needs.

If you’re just getting started, it can also help to get a clearer sense of your home’s current value. HomeLight’s free Home Value Estimator can give you a quick snapshot of where you stand today.

That said, some loan programs are more flexible and may still approve you depending on your overall financial picture. Factors like your home equity, income, and payment history can also play a big role in your chances of getting approved. It may take a little extra shopping around to find the right lender or program that fits your situation.

Writer Summer Rylander contributed to this story.

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