Mortgage Refinance Basics: How it Works
1. What is a Refinance?
A mortgage refinance is when you replace your old mortgage loan with a new one that has different terms.
When you refinance, you can change a few different parts of your mortgage.
First, you can adjust the length of the loan so it’s shorter or longer.
A shorter loan will have higher monthly payments while a longer loan will have lower monthly payments.
Another option is to refinance to change the size of the loan.
You can make a lump sum payment as part of the refinance so you owe less money.
If you’ve paid off some of your existing mortgage, you can refinance to borrow that money again.
This will give you cash today but will increase the size of your loan so it will take longer to pay off your house.
This is known as a “cash-out” refinance.
You might also be able to refinance to a lower interest rate, which would lower your payments.
Finally, you can switch your mortgage from a variable loan to a fixed loan or vice versa.
Usually, people refinance from a variable loan to a fixed loan so they can lock in a set monthly payment that stays the same.
How to refinance a mortgage
The process of refinancing your mortgage is similar to when you first applied for the original loan.
You contact lenders and let them know that you’re looking for a refinance.
You can refinance with your current lender or you can move your loan to another company.
When you apply, the lenders will review your current loan, credit score, and financial situation to decide if you qualify for a refinance.
If you qualify, they’ll send you a new loan offer with the refinance information.
If you’re happy with the new loan terms, the lender will guide you through the paperwork to replace your old loan and complete the refinance.
2. When Should You Refinance?
Why refinance a mortgage
People refinance their mortgages because they think new loan terms would make more financial sense.
If you’re wondering when to refinance, there are a few situations to look out for.
A good reason to refinance is because you think you can qualify for a significantly lower interest rate that will lower your monthly payments.
Your rate could be lower because market interest rates have gone down since you first took out your mortgage or because your credit score has improved.
The mortgage refinance rates should be at least 1-2 percent lower than your current interest rate, so for example, if your rate is 5 percent, it would be ideal to go down to 4 percent.
You need at least this much of a drop to recoup the upfront cost of refinancing.
Otherwise, you won’t save enough on your monthly payments to make the fee worthwhile.
Another reason to refinance is because you want to change your monthly payments by adjusting the length of your mortgage.
Finally, if you’re tired of the unpredictable payments on a variable mortgage, you can lock in a set monthly payment by refinancing to a fixed mortgage.
When not to refinance
Since refinancing costs a fairly sizable upfront fee, it takes time to make that money back in lower monthly payments.
If you’re planning on moving in the near future, refinancing probably doesn’t make sense.
If you think you’ll be able to qualify for an even better rate in the near future, say because your credit score will improve, you should hold off so you can later lock in the best mortgage refinance rates.
Lastly, make sure your current loan doesn’t charge an early cancellation penalty.
Some loans charge a costly penalty if you refinance too soon after taking out the original mortgage.
3. Affordable Refinance Programs
Home Affordable Refinance Program (HARP)
The government has created a few mortgage refinance programs to help borrowers who might not be able to qualify for a regular refinance.
One popular program is the Home Affordable Refinance Program, or HARP.
A regular refinance usually only makes sense when your outstanding mortgage balance is less than 80 percent of the value of your home.
Otherwise you’ll have to pay extra mortgage insurance costs as part of the refinance, which would wipe out most financial benefits.
When the price of homes collapsed after the housing bubble, many Americans couldn’t qualify for affordable mortgage refinances.
The HARP program let them refinance without the extra insurance costs because the government guarantees the mortgage.
The Federal Housing Administration is another government agency that helps homeowners.
First, Americans who can’t qualify for a regular mortgage can apply for an FHA loan.
The FHA guarantees the loan to help the applicants qualify.
If you have an FHA loan, you can take out an FHA streamline refinance. This program makes refinances easier, faster, and more affordable.
With a regular refinance, you need a home appraisal to reset the value of your loan. This takes time and money.
When you apply for an FHA refinance, you use the value of your house when you first bought it to set the new loan amount.
Also, there is no check of your credit or employment.
As a result, the FHA refinance application process only takes weeks instead of months and the fees are lower.
FHA refinance rates are also lower than regular refinance rates. However, this benefit gets cancelled out over time because the FHA charges higher insurance costs over the entire mortgage.
If you can also qualify for a regular refinance, you should compare the total cost of both options.
4. Are You Eligible to Refinance?
Not everyone can qualify for a refinance.
First, you have to be up-to-date with the payments on your current mortgage.
If you’re in default on your loan, you can’t refinance.
You need to own at least some of the property outright as well, meaning, the size of your loan is smaller than the value of your property.
Lenders also usually want to see a good credit score, around 700 or higher, since the mortgage refinance approval process is similar to applying for a new mortgage.
Mortgage lender with bad credit
If your credit score isn’t great, you might still be able to qualify for a refinance.
Some lenders are willing to accept applicants with weaker scores, even scores below 600.
You can help your case if you don’t have many other debts or your income is high compared to your mortgage payments.
Refinancing with bad credit will be more expensive because you won’t qualify for the best rates.
You need to ask yourself whether it really makes sense to refinance now or if it wouldn’t be better to improve your score first so you can refinance at a better rate later.
FHA mortgage requirements
The FHA program makes it much easier to qualify for a refinance but there are still requirements.
First, you can only take out an FHA refinance if you already have an FHA loan. Other mortgages won’t qualify.
Also, you need to show a clear mortgage benefit from refinancing, for example, you’re switching to a loan with a lower interest rate or switching from a variable rate to a fixed rate.
Keep in mind you can’t cash out money with an FHA refinance and you can’t be in default on your mortgage payments.
However, there are no credit or employment checks for FHA refinances.
5. The Cost of Refinancing
Refinance application fee
Lenders charge a fee for refinancing. First, they charge an application fee to start the process.
This covers the cost of handling your paperwork and looking up your credit history.
You’ll likely need to pay this fee whether you qualify for a refinance or not.
According to the Federal Reserve Board, this fee usually ranges from $75 to $300 but the fee could be different depending on which lender you use.
Check with your lender to see exactly how much you’ll pay for every fee.
Refinance loan origination fee
If you qualify for a refinance and decide to apply for the new loan, the lender could charge a loan origination fee.
This is a percentage of the amount you borrow and typically goes up to 1.5 percent.
For example, if you refinance for $200,000 and the origination fee is 1 percent, you’ll pay $2,000 for this charge.
Not all lenders charge origination fees.
Points are another upfront fee for refinancing. Each point is 1 percent of the total loan amount.
If you refinance for $100,000 and pay 2 points, the cost will be $2,000. There are two kinds of points.
Some lenders charge points instead of an origination fee and you have to pay these points to start up the new loan.
Other lenders charge optional points which are like prepaid interest.
By paying these optional points at the start of your refinance, your monthly payments will be lower over the actual loan.
Refinance appraisal fee
Lenders require an appraisal of your home as part of the application process.
This is to make sure that you’re not borrowing more than the house is worth. The appraisal fee ranges from $300 to $700.
Refinance closing fee
To complete the refinance process, the lender needs to hire a lawyer and will pass this cost on to you. The refinance closing cost usually ranges from $500 to $1,000.