What Is Mortgage Refinance?

What Is Mortgage Refinance?
••• stanciuc/iStock/GettyImages

Are you considering a mortgage refinance? With interest rates low right now, it could be a good time to think about one. Refinancing your mortgage can lower your monthly mortgage payments or shorten your loan terms. It can also put money in your pocket for home improvements or to pay off higher-interest debt, like credit card debt.

A mortgage refinance occurs when you take out a new home loan to pay off your existing mortgage. If your goal is to lower your payments or shorten your loan terms, you can borrow the amount you currently owe on your house.

You might also consider a cash-out refinance, where you borrow more than the amount of your existing mortgage. Depending on the loan, you may be able to borrow as much as​ 85 percent​ of your home’s current appraised value.

The bank will loan you the difference between your current mortgage and the new mortgage in cash.

Lower Your Interest Rates with a Mortgage Refinance

A mortgage refinance can help homeowners in many different ways. There are many reasons for borrowers to refinance their home mortgages. Often, there is more than one good reason.

Refinancing your mortgage right now may reduce your monthly mortgage payments and the total amount of your home loan, if you purchased your home when interest rates were higher.

Right now, in December 2020, the Federal interest rate, otherwise known as the prime rate, sits at ​0.25 percent​. Last year, the prime rate was ​1.75 percent​. In 2008, it was ​3.5 percent.

Refinance rates are calculated as a function of the prime rate, which means if the prime rate goes down, so do refinance rates.

As an example, if you purchased your home in 2008, you’ve been making mortgage payments for ​12 years​ and have built up some equity in your house. You could lower your interest rates by refinancing at today’s lower interest rates. You can also borrow money against the equity in your home while lowering your monthly payment and/or reducing your loan terms.

If your personal financial situation has improved since you got your mortgage, you may qualify for a lower interest rate even if the average refinance rate hasn’t dropped since you bought your house. If you improved your credit score or your debt-to-income ratio since you applied for your mortgage, you could qualify for a lower percentage rate now.

Other Reasons You May Want to Refinance

In addition to reducing the total cost of your mortgage and lowering your monthly payment, there are other reasons you may want to consider mortgage refinancing.

If you originally chose an adjustable-rate mortgage, or ARM, you can refinance to lock in a lower interest rate. You won’t have to worry about your monthly mortgage payments increasing if the Fed raises interest rates.

You may consider mortgage refinancing as a way to remove someone from your mortgage. For instance, if a couple divorces but one person wants to keep the home, they might wish to refinance to remove their former spouse’s name from the mortgage. They would also have to file a legal document to remove their ex’s name from the deed of the house.

If you have an FHA loan and you are currently paying private mortgage insurance (PMI) you may want to refinance, leaving at least 20 percent equity in the home, to eliminate that added mortgage insurance payment each month.

Finally, one of the most common reasons to refinance a home is to pull out cash to pay off higher-interest debt. People also use the money from a cash-out refinance to make home improvements, pay for emergency expenses, pay for college, start a business or even fund a luxury like a vacation.

With interest rates so low, it pays to borrow against your home equity to make an investment that may have a more profitable yield. For instance, if you have an investment opportunity where you could make 10 percent, it might pay to take out a loan at 3 to 5 percent to fund that investment. You can also tap into your home’s equity to start a business that could net large profits in the future.

Pros and Cons of Refinancing Your Mortgage

As with any financial decision, you’ll have to consider your specific circumstances to decide if a refinance or cash-out refinance is the right choice for you.

Some of the pros of refinancing your mortgage include:

  • Locking in a lower interest rate
  • Converting an adjustable-rate mortgage to a fixed rate mortgage
  • Eliminating private mortgage insurance
  • Borrowing cash at a low interest rate by tapping into the equity in your home
  • Securing a shorter term for your mortgage
  • Reducing your monthly mortgage payments

Some of the drawbacks to refinancing your mortgage include:

  • Paying closing costs and loan fees
  • Getting a home appraisal
  • Filling out paperwork
  • A slight credit score drop when you apply for a mortgage refinance

It’s important to calculate the closing costs, loan fees and points on your mortgage refinance before you go ahead with the deal. If you aren’t going to make back that money before you sell your house, a refinance might not make sense.

Similarly, if mortgage refinancing won’t lower your payments considerably or provide a shorter term, it may not be a good idea for you right now.

What Are Good Refinance Rates?

At any given time, average mortgage rates tend to be lower than refinance rates or cash-out refinance rates. Banks view refinances as riskier than first mortgages. You’ll pay more to refinance than you would pay for a mortgage on any given day, with all other factors being equal.

However, all other factors probably are not equal if you’re considering a refinance. For instance, if you purchased your home years ago, when the prime rate was higher, today’s refinance rates will be lower than previous mortgage rates.

Similarly, if your credit score or debt-to-income ratio has improved over the years, you may be able to secure a lower rate now, especially since interest rates in general have dropped so much this year.

In December 2020, the average refinance rate for a ​30-year​ fixed mortgage is ​2.90 percent​. A ​15-year​ fixed mortgage carries an average interest rate of ​2.42 percent​, and a ​10-year​ fixed loan is ​2.43 percent​, on average.

To determine a good refinance rate, compare your offer to today’s average rates. You may also compare your refinance offers to historic averages from the past year or two. With the prime rate at 0.25 percent and the Federal Reserve announcing they will keep the federal funds rate between zero percent and 0.25 percent through 2023, now could be a good time to refinance. The last time interest rates have dipped this low was in 2008 during the financial crisis.

When you’re comparing refinance rates, make sure to factor in the closing costs, fees and points as well.

What are Mortgage Points and Why Are They Important?

Paying mortgage points can lower your monthly payments by reducing your interest rate. Each “point” you pay at closing reduces the mortgage interest rate by about 0.25 percent, although this amount varies by lender. A mortgage point represents 1 percent of the total loan amount.

Let’s say you are taking out a $200,000 home equity loan with a 15-year fixed-rate mortgage at an interest rate of 2.5 percent, which is just a little above the national average right now. You can pay $2,000, or one point, at closing, and then pay back the loan at 2.25 percent, instead.

Buying points to reduce your interest rate can make sense in the long term if you plan to stay in the house long enough to recoup those costs.

When you compare refinance rates, the APR includes the total interest you will pay, including points, while the interest rate does not include points. The interest rate and APR would be exactly the same for a home loan with no points. However, adding points to the mortgage would make the APR higher than the monthly interest rate. You’re still paying that interest, but you’re paying it in a lump sum at closing.

Make sure you’re comparing the same numbers when you shop around.

What Should You Look for in a Lender for Your New Mortgage?  

You’ll want to consider your goals when you begin mortgage refinancing. Do you want to reduce your 30-year mortgage to a shorter term? Reduce your monthly payments?

Look for a lender that provides the terms you want at interest rates that would allow you to save money vs. your existing mortgage.

Some lenders offer loans with no closing costs, but that just means you won’t pay those expenses upfront. The lender will roll the closing costs into the loan or you will pay a higher interest rate.

If you’re planning to do a cash-out refinance, find out how much of your loan’s total value you can borrow. Some lenders will allow you to borrow as much as ​85 percent​ of your home’s equity.

You may prefer a lender who works entirely online, including permitting you to sign closing documents digitally. Or you may want face-to-face service, which is growing less common in recent times.

You may also look for a lender that allows you to close quickly.

Read consumer reviews to ensure you’ll get the level of service you expect.

How Do You Refinance Your Home Loan?

Once you find a few lenders you like, request loan estimates from each one. This three-page document shows the loan terms, closing costs, fees and your monthly payment. Once you find a lender you like, you’ll want to lock in your interest rate, the same as when you applied for your current mortgage.

Refinancing a home is similar to applying for a mortgage in many ways. Your lender will require a home appraisal and will check your FICO credit score. Your lender will compare your debt-to-income ratio to ensure you can afford the new loan. You’ll also need to show proof of income.

What’s the Difference Between a Cash-out Refinance, Home Equity Loan and Home Equity Line-of-Credit?

When you refinance your mortgage, you are only borrowing the amount you owe on your existing mortgage.

A cash-out refinance lets you borrow up to 85 percent of your home’s appraised value.

A home equity loan also lets you borrow up to 85 percent of your home’s value, but you aren’t refinancing your existing mortgage. You are taking out a second mortgage only for the amount you’re borrowing. You will hold and pay two mortgages each month.

There’s another way you can tap into your home’s equity, too. You can apply for a home equity line of credit. A home equity line of credit allows you to borrow against your home’s equity on a revolving basis.

While you can refinance with a fixed rate, most HELOCs have variable interest rates. But you only have to pay back the money you use. If you do a cash-out refinance, you receive the full loan amount. Even if it sits in a bank and you don’t spend it, you still have to pay it back monthly.

On the other hand, a HELOC gives you access to money, as needed, with your home’s equity as collateral for the loan. You can take out money as needed during the loan’s draw period, usually 10 years.

As you pay back the money, you replenish those funds and can borrow them again during the draw period. Once the draw period ends, you’ll enter the repayment period. You will begin paying back the entirety of the money you borrowed, usually over a period of 20 years.

A cash-out refinance or home equity loan only gives you access to the money once. If you wanted to borrow against your home’s equity again, you’d need to take out a HELOC or do another cash-out refinance.

If you’re looking to reduce your monthly mortgage payments, you might consider refinancing while interest rates are low.