How Does Refinancing a Home Mortgage Work?

How Does Refinancing a Home Mortgage Work?
••• scyther5/iStock/GettyImages

With the economy suffering more than ever due to the COVID-19 pandemic, consumers are looking to do everything they can to get a leg up financially. That means taking advantage of every offer, discount and negotiating tactic to lower expenses.

Thankfully, interest rates are currently lower than they've been in years – and homeowners are scrambling to take advantage of the refinancing options available. These low rates won't last, so time is of the essence for anyone looking to close a deal.

If refinancing is a new topic for you, we've got you covered. Here's what you need to know about how a home mortgage refinance works.

How Does Refinancing Work?

Refinancing is the process of switching out your old mortgage for a new one, usually to save money on interest or lower the monthly payment. Most borrowers refinance with a new lender, but sometimes you can refinance with the same lender.

The process of refinancing a home is similar to buying one. First, you have to shop around for refinance offers from several lenders. The lenders will check your credit report and verify your employment, income and assets to determine what kind of refinance terms you qualify for.

Once you’ve chosen a lender, they’ll conduct an official appraisal to determine the value of your home. If the value has decreased significantly and you now owe more than the home is worth, you won’t qualify for a refinance. On the other hand, if your home’s value has increased, then you're likely a good candidate for a refinance.

Reasons to Refinance

There are a variety of reasons to refinance, and each has its own benefits and drawbacks:

1. Decrease Monthly Payment

Borrowers usually refinance to lower their monthly payment. For example, let’s say you owe $250,000 on a 30-year loan with a 5% interest rate. If you refinance to a 30-year loan with a 3% interest rate, you’ll save $264 a month or $27,348 in total interest over the life of the loan.

2. Shorten Loan Term

Borrowers who choose a shorter-term loan will get a lower interest rate than those who choose a longer-term loan. If you can afford to refinance to a 15-year or 20-year loan instead of a 30-year loan, you may see a huge difference in the interest rate and the total interest paid.

Here’s how that works. Let’s say five years ago, you took out a $200,000 30-year mortgage with a 4.5% interest rate. Now, you refinance to a 20-year loan with a 3.5% interest rate. Your new monthly payment is $46 more than the previous payment, but you’ll save $14,876 in total interest over the life of the loan. Plus, you’ll pay off the mortgage five years sooner than you originally thought.

3. Remove PMI

Borrowers who put down less than 20% when they buy a home will usually have to pay Private Mortgage Insurance (PMI). But if your home jumps in value, you can refinance to remove PMI from your monthly payment. PMI costs between .5% and 1% of the mortgage annually, so you could save hundreds of dollars a year.

Even if you don’t quite meet the 20% equity requirement, you can still reduce the cost of PMI by refinancing. For example, lenders will often charge a lower PMI fee if you have 15% equity compared to 5% equity.

4. Take Cash Out

A cash-out refinance is when you can tap the equity in your home by refinancing.

The maximum amount that borrowers can withdraw is between 80% to 90% of their home’s equity, minus the remaining balance. For example, let’s say your home is worth $300,000, and you have $100,000 left on the mortgage. You could use a cash-out refinance to withdraw up to $140,000.

You can choose to take the maximum amount available in a cash-out refinance or a lower amount.

The money from a cash-out refinance can be used to pay off debt, fund a child’s college education or remodel the home. Borrowers interested in a cash-out refinance can contact Figure Refinance to get a quote.

What to Consider Before Refinancing

Sometimes when homeowners refinance, they actually end up paying more interest over the life of the loan. Here’s an example. Let’s say you took out a $200,000 mortgage 15 years ago. The interest rate was 4.5% on a 30-year term.

Now, 15 years later, you refinance to a 30-year mortgage with a 3.5% interest rate. Even though your interest rate is lower now, you’ll actually end up paying $2,075 more in interest over the life of the loan because you extended the repayment timeline. Before refinancing, you should run the numbers and see how much more you’ll pay in interest.

Borrowers should also consider how long they plan to stay in the home before refinancing. Refinancing includes closing costs, so it may take a few years to break even on the deal.