What Is Refinancing, And What Does It Mean To Refinance A House?

10 Min Read
Updated March 13, 2024
FACT-CHECKED
Written By
Ashley Kilroy
Woman with infant preparing to refinance her home loan.

Unlocking the potential of your mortgage is like discovering a map to financial freedom. With mortgage refinancing, you can rewrite the terms and replace your existing loan with one that benefits you even more. For example, refinancing can lower interest rates, reduce monthly payments or allow you to borrow against your equity – all strategic moves to maximize wealth. What is refinancing and how can you avoid the pitfalls of getting a new mortgage? Read on to find out.

What Does ‘Refinance’ Mean?

Loan refinancing refers to replacing an existing loan with a new loan, paying off the existing one. The new loan may come with better interest rates, shorter or longer repayment terms or money to use to consolidate debt or make home improvements.

People often refinance their loans to take advantage of lower interest rates, reduce monthly payments, extend or shorten the loan term or switch from an adjustable-rate mortgage to a fixed-rate loan (or vice versa). You can refinance with various types of loans, including mortgages, auto loans, student loans and personal loans.

The primary goal of loan refinancing is usually to save money over the life of the loan. By securing a lower interest rate or extending the repayment period, borrowers reduce their monthly payments and could decrease the overall cost of borrowing. However, it’s crucial to consider any fees or closing costs associated with refinancing, as they can affect the overall savings. Therefore, before deciding to refinance a loan, it’s advisable to evaluate the terms and costs of the new loan carefully.

See What You Qualify For

What Does It Mean To Refinance A Home Loan?

The loan refinancing process is similar to the original home loan process. Specifically, your first step is to shop for lenders. Because you aren’t obligated to refinance with your current lender, you may decide to gather offers from numerous sources. Then you can choose the refinance option that fits your situation best (for example, the one with the lowest monthly payment if making room in your budget is the goal). Remember, the higher your credit score, the better your interest rate will be.

When you find the right offer, you can replace your original loan with the new one. Your refinance lender will pay off the old loan, and you’ll start paying the new refinance loan instead. Ideally, this loan will have more favorable terms and lower your monthly payment.

To qualify for most refinances, you must be named on the ownership documents and own the home for 6 months or longer. In addition, having a credit score of 620 or higher will help you qualify for more refinance options. However, if you have a median FICO® Score of 580 and low enough debt, you may qualify for an FHA or VA refinance loan.

Generally, you’ll need at least 20% equity in your home to refinance. However, exceptions exist for homeowners with less than 20% equity, as outlined below:

20% Home Equity Or More

A general rule of thumb is to have at least 20% equity in your home if you want to refinance. Refinancing with this amount of equity allows you to eliminate private mortgage insurance (PMI), significantly lowering your monthly mortgage payment. Likewise, the 20% threshold is what you need to qualify for a cash-out refinance.

Under 20% Home Equity

If your equity is under 20% but you have a good credit rating, you may still be able to refinance. However, your lender may charge you a higher interest rate or require you to pay for mortgage insurance. Remember, interest-reduction FHA refinance loans don’t have equity requirements. 

Types Of Refinancing

Borrowers have numerous reasons for refinancing. Fortunately, several types are available to address various situations:

  • Cash-out refinance: A cash-out refinance converts your home’s equity into cash while refinancing your mortgage. A cash-out refi can help you consolidate higher-interest debt, saving you money. Cash-out refinancing is also excellent for borrowers with a lot of equity to use for home improvements. Remember, a cash-out refinance replaces the borrower’s current mortgage, and the monthly payment amount is different under the new agreement. Because you’re withdrawing cash, your loan principal increases, meaning your monthly payment may increase.
  • Rate-and-term refinance: rate-and-term refinance lets the homeowner change their loan’s mortgage rate, loan term or both while the loan balance is unchanged. This refi type can help you save money through a lower interest rate. In addition, you can extend the loan term, lowering your payments by spreading them out over a longer period.

If you refinance to a shorter loan term, your monthly payments will be higher because you’re paying off the same amount of money in less time. However, you save money in the long run by removing years of interest payments.

  • Streamline refinance: Streamline refinancing is similar to rate and term refinancing, but it’s specifically for government-backed loan programs (FHA, USDA, and VA). Streamline refis offer simplified processes with reduced documentation requirements and underwriting standards. The three types of streamline refinance programs available are FHA Streamline Refinance, VA IRRRL and USDA Streamline-Assist Refinance. Each of these options lowers your interest rate and monthly mortgage payment. In addition, they typically don’t require an appraisal or a credit check.
  • Cash-in refinance: If you’ve come into a lump sum of cash you wish you’d had when you bought your home, a cash-in refinance allows you to put the money into a new down payment. Furthermore, this refi can get you a better interest rate and eliminate PMI premiums by building your equity and reducing your loan-to-value ratio. 
  • No-closing-cost refinance: A no-closing-cost refinance allows borrowers to conserve their funds by avoiding the upfront expenses of refinancing. By eliminating the upfront costs, they can use the saved funds for other purposes, such as paying off high-interest debt. However, a no-closing-cost refinance doesn’t mean that the borrower avoids paying closing costs altogether. Instead, the costs are incorporated into the loan balance or paid over time through a higher interest rate. Therefore, this option is advantageous for individuals who plan to refinance again or sell within a few years before the higher loan payments eat into their initial savings.
  • Short refinance: A short refinance helps borrowers in danger of foreclosure by implementing a new mortgage with a smaller balance. This way, monthly payments become more affordable and help the borrower stay in their home.

Common Reasons For Refinancing

Here are some common reasons that homeowners refinance their mortgages.

To Have A Lower Monthly Payment

Some borrowers refinance their mortgages to secure a lower payment through a lower interest rate or longer loan term. Doing so can improve your monthly cash flow, lightening financial strain. Remember, improving your credit score once you become a homeowner can help you get a lower interest rate when refinancing, though market conditions will impact interest rates. In addition, you can remove PMI by refinancing once you have 20% equity in your home, thus lowering your monthly payment even if interest rates haven’t changed.

To Choose A New Loan Term

Refinancing allows borrowers to select a new loan term, such as switching from a 30-year mortgage to a 15-year mortgage and vice versa. Shortening the loan term can help homeowners build equity faster and save on interest payments over time. Conversely, borrowers can opt for a longer loan term to extend payments and lower their monthly obligation.

To Get A Different Loan Type

Refinancing allows you to switch between loan types. For example, you can go from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage. With an ARM, the interest rate fluctuates over time, while a fixed-rate mortgage offers a stable rate for the entire loan term. Therefore, refinancing allows you to benefit from the ARM’s initially low interest rate and change it out for a fixed-rate mortgage after several years.

See recommended refinance options and customize them to fit your budget.

Pros And Cons Of Refinancing

Remember, there are both pros and cons to refinancing. Whether it’s a beneficial decision depends on your circumstances and goals. Here’s what to consider if you want to refinance:

Pros

  • Refinancing can lock in a lower interest rate.
  • Refinancing may mean a lower monthly payment.
  • Refinancing can lengthen or shorten a loan term, depending on borrower preference.
  • Refinancing can turn equity into cash, providing a needed financial bump.
  • Refinancing can eliminate an ARM and help maintain a low interest rate.

 

Cons

  • Refinancing requires paying closing costs on a new loan (between 2% – 6% of the loan amount).
  • Refinancing could shorten your loan term, resulting in a higher monthly payment.
  • The new loan may take longer to pay off.
  • A cash-out refinance creates a larger loan balance, possibly increasing monthly payments and lengthening the loan term.

How To Refinance Your Home Loan

Refinancing is a multistep process resembling what borrowers did to obtain their original mortgage. As a result, this list includes the standard requirements for refinancing, such as strengthening your finances and compiling the necessary paperwork.

1. Check Your Credit Score

It’s essential to check your credit score and assess your creditworthiness. A higher credit score can improve your chances of qualifying for better loan terms and interest rates. If necessary, take steps to improve your credit score, such as paying down debts or resolving errors on your credit report.

2. Look At Your Home Equity

You can determine your home equity by comparing the current value of your home to the amount you owe on your existing mortgage. For example, if you owe $200,000 on a $350,000 home, you have $150,000 of equity. Lenders often require at least 20% equity to approve a refinance. Remember, having more equity can increase your chances of getting more favorable terms and options.

3. Shop Around For The Right Lender

Research and compare offers from multiple lenders, including banks, credit unions and online lenders, considering factors such as interest rates, fees, loan terms and customer reviews. In addition, examining specific policies, such as autopay and prepayment penalties, can help you choose the right lender. Getting quotes from several lenders is also advisable to find the best refinancing option.

4. Gather Required Documents

Prepare necessary documentation for a refinance, such as income verification (pay stubs, tax returns), bank statements and proof of assets. Lenders will also require information about your current mortgage, property and insurance. In addition, you can submit a letter of explanation to address a gap in your employment or a problematic item on your credit report.

5. Apply For Your New Loan

Once you choose a lender, the process of submitting a refinance application is similar to getting a mortgage purchase loan. You’ll provide accurate and complete information about your financial situation and your home. You may also need to pay an application fee.

6. Get A Home Appraisal

While your lender considers your application, they will arrange a home appraisal with a licensed appraiser to determine the home’s market value. This way, you’ll get an unbiased calculation to confirm how much equity you have.

7. Close On Your New Loan

After approving your application, finishing the appraisal and performing a title search, your lender will send a Closing Disclosure for your review. This document contains the loan terms, including interest rate, closing costs and repayment schedule. If you agree to the terms, you’ll close on a refinance by attending a meeting where you sign the necessary paperwork. In addition, you’ll pay the closing costs, including origination fees, appraisal fees and title insurance.

FAQs About What It Means To Refinance

The answers to these frequently asked questions will help clarify whether a refinance suits you.

What exactly does refinancing do?

Mortgage refinancing replaces your existing mortgage with a new loan with different terms, such as a lower interest rate or a changed repayment period. It’s beneficial because it allows you to reduce your monthly payment, access equity or change your loan type. However, because the refinance incurs closing costs and can result in a higher loan balance, it’s crucial to consider your financial goals, current market conditions and the costs before refinancing.

Is it a good idea to refinance a loan?

When deciding to refinance, it’s critical to have a defined goal, such as lowering your interest rate or reducing monthly payments. In addition, you can access a lump sum of cash if you have sufficient equity. But remember, refinancing costs can outweigh the benefits if you plan to sell the property soon or if your credit score is too low to secure better terms.

What is the risk of refinancing?

Refinancing might not achieve significant savings because of the closing costs, which are 2% – 6% of the new loan balance. Second, refinancing can extend the loan term, resulting in more overall interest paid over time. Lastly, your financial circumstances or property value could lead to an underwater mortgage or reduce your ability to meet the new loan terms.

The Bottom Line

Refinancing can help you lower your interest rate, reduce monthly mortgage payments, access equity and change your loan type. However, the drawbacks, including closing costs, a larger balance and extending the loan term, can nullify the benefits. Therefore, it’s vital to consider your goals and the associated costs and risks before deciding to refinance. 

See recommended refinance options and customize them to fit your budget.

Share: