Refinance Your Mortgage: How It Works and What It Costs

Refinancing a mortgage can save you hundreds per month on your mortgage payments or accelerate how quickly you pay off your home loan. But a refinanced mortgage tends to come with steep closing costs and lots of paperwork, so you’ll need to carefully assess whether it makes sense for you by talking with your lender.

We’ll help you decide if you should refinance your mortgage. We’ll look at what refinancing means, how much refinancing costs, how the process works, and when refinancing is a good option to consider. 

What does it mean to refinance a mortgage?

Refinancing a mortgage means taking out a new home loan to replace your current one. When you refinance your mortgage, your lender will pay off your current mortgage, allowing you to make payments on the new mortgage with its own interest rates and term length.

A refinance works similarly to a new mortgage, but instead of financing the purchase of a home, it replaces your existing loan. You can refinance into a conventional mortgage (for example, to remove FHA mortgage insurance), or into another loan type. Homeowners often refinance to secure a lower interest rate, change their loan term, switch between fixed and adjustable rates, or tap into their home’s equity.

When choosing a mortgage lender for a refinance, it’s essential to shop around. Refinance mortgage rates and terms vary significantly depending on your credit score, market conditions, income, and home equity.

How much does it cost to refinance a mortgage?

It costs around 2–5% of your total loan amount in closing costs to refinance a mortgage. For example, on a $400,000 refinance, that means closing costs could be between $8,000 and $20,000. Closing costs may include the following costs and fees, depending on your lender and where you live:

• Origination fees
• Application fee
• Appraisal costs
• Title search
• Insurance fee
• Credit report fee
• Recording fee
• Attorney fees

You can also potentially reduce your long-term mortgage costs by buying mortgage points. Mortgage points reduce your interest rate in exchange for an upfront cost. Typically, one point costs 1% of your loan amount and will lower your interest rate by 0.25%.

Mortgage points can be a good idea if you plan on staying in your home for a while without refinancing. However, you may not hit your break-even point if you move or refinance within the next few years.

You can also find lenders who offer refinancing with zero closing costs. But while these offers might sound great, be aware that the costs are often rolled into your interest rate. That’s why, when comparing mortgage lenders, you should focus on APR, which incorporates both interest rates and fees.

Understanding refinance rates

Like new mortgage rates, refinance rates fluctuate depending on Federal Reserve policy and current market conditions. According to Freddie Mac, the current average mortgage rate is 6.17%. To give you an idea of how much rates can fluctuate, the average mortgage rate was 6.72% a year ago and 2.81% five years ago.

The most important factor in determining your refinance rate is usually your credit score. Improving your credit score from good to excellent can make you eligible for interest rates that are 0.5% or more lower, which adds up to thousands of dollars saved over time.

If your loan-to-value (LTV) ratio is also low, you’ll typically get better rates. In other words, if you have less debt and more equity in your home, lenders will see you as being a lower risk and offer you better terms.

The loan type also affects your rate. Shorter-term loans, such as 15-year mortgages, typically have lower interest rates than 30-year mortgages. However, you’ll be paying larger monthly installments because of the accelerated repayment schedule. Cash-out refinances often have higher rates, while regular rate-and-term refinances have lower rates.

When comparing the top mortgage lenders, keep in mind that the advertised rates often reflect scenarios where borrowers have excellent credit and plenty of equity. Your actual interest rate is personalized to you depending on your credit rating, financial situation, and equity.

How to refinance a mortgage

To refinance a mortgage, you’ll typically follow this step-by-step process.

Step 1: Decide on your goals.

Your reasons for refinancing will determine how you search for a new mortgage. Refinancing goals can include lowering your monthly payments, accessing cash through equity, or reducing the overall length of your loan to pay it off faster. Make sure every lender you talk to is aware of what you want to accomplish by refinancing.

Step 2: Improve your credit score.

Your credit score is among the most important factors in getting a lower rate, so review your credit report to understand where you currently stand. If your credit score is under 700, you may want to focus on reducing your debt and making monthly payments to improve it before applying to refinance your mortgage.

Step 3: Understand your home equity.

Refinancing makes the most sense if you have at least 20% home equity — and many lenders require this amount as a minimum to qualify. If you don’t yet have that much equity, try making a few more months of payments on your current mortgage.

Step 4: Compare multiple lenders.

Shop around banks, credit unions, and online lenders to make sure you’re getting the best rate and terms. Aim to get at least three to five offers. When comparing offers from lenders, don’t focus exclusively on the interest rate. Closing costs can be significant, plus factors like customer service and processing times may be just as important to you personally.

Step 5: Prepare your documentation.

When you’re ready to apply for a refinance, you’ll need to have your documentation in order. The documents required are similar to when you applied for your original mortgage and typically include pay stubs, bank statements, insurance policies, and mortgage statements.

Step 6: Lock in your interest rate.

Once you’ve selected a lender, you can typically lock in your interest rate. Rate locks usually last for 30 to 60 days and protect you from rising interest rates during the application process.

Step 7: Complete appraisal and underwriting.

In most cases, your lender will require an appraisal to make sure your property’s value can cover the mortgage amount. They’ll also begin the underwriting process to verify your financial information and eligibility. The entire process typically takes 30 to 45 days, but some lenders can move much faster, completing the process in less than a month.

Step 8: Prepare for closing.

You’ll receive your closing disclosure at least three days before closing. Take this time to review it carefully. Check to make sure the terms are the same as what you agreed to. On closing day itself, you’ll need to provide funds for the closing costs and bring identification. Once closing is complete, your old mortgage will be paid off, and your new one takes effect.

When should you refinance a mortgage?

Finding the ideal moment to refinance your mortgage is difficult. Trying to time the market is usually a bad idea—nobody can predict with certainty when rates will reach their lowest or start climbing again.

These factors, however, can help you decide when to refinance a mortgage:

• Interest rates are lower: If current interest rates are 0.75% to 1% lower than your current rate, you could save money by refinancing.
• Your credit score is higher: If your credit score has increased significantly since you obtained your current mortgage, refinancing could qualify you for a lower rate.
• Financial situation has improved: If your income has increased substantially or you have more savings, you’ll be seen as a lower risk to lenders, which often helps you get a better rate.
• ARM adjustment period: If your adjustable-rate mortgage is approaching its adjustment period, refinancing to a fixed-rate mortgage can shield you from suddenly having to pay much higher interest rates.
• Consolidate your debts: In some situations, using a cash-out refinance allows you to consolidate high-interest debts into a lower-rate mortgage. However, this move doesn’t always make sense financially, so you’ll need to discuss it with a financial advisor first.

When in doubt, talk with a mortgage professional to see if refinancing is wise for your specific situation. 

Types of mortgage refinancing

There are four main types of mortgage refinancing. Each one can help satisfy different goals and financial needs.

Rate-and-term refinance

Rate-and-term is the most common type of refinance and is what most people think of when they think of refinance mortgages. This option changes your interest rate, loan term, or both. It doesn’t actually change the amount owed.

Homeowners choose rate-and-term refinance because they want a lower interest rate, reduced monthly payments, or a shorter loan term to build equity faster. A rate-and-term refinance impacts the structure of your principal and interest payments, with shorter terms leading to higher payments but less total interest paid over the entire loan term.

Cash-out refinance

A cash-out refinance is when you borrow more than is currently owed on your mortgage, allowing you to take out the difference in cash. This option is commonly used for major expenses like home improvements or for debt consolidation.

Cash-out refinances require you to typically have at least 20% equity in your home. Plus, the interest rates are usually higher than they would be for rate-and-term refinancing.

Cash-in refinance

Cash-in refinancing is when you bring in your own money to reduce your overall mortgage balance. While this option is rare, it can make sense financially since it helps you qualify for lower rates and payments. It may also allow you to eliminate your private mortgage insurance (PMI) or help you pay off your mortgage sooner.

This option typically makes the most sense if your financial situation has dramatically improved, such as from an income increase or inheritance.

Streamline refinance

Streamline refinance is available for borrowers with FHA, VA, and USDA loans. The process requires less documentation than a normal refinance and often doesn’t require a new appraisal.

Streamline refinance is often a good option if you have a government-backed loan and want to take advantage of lower rates, but without the hassle of a typical refinance application.

Should I refinance my mortgage?

Refinancing can be a good choice if you’re looking to reduce your interest rate, monthly payments, or the speed at which you pay off your mortgage. However, it’s important to consider other factors, such as how long you plan on staying in your home, the current interest rate environment, closing costs, and your financial goals.

Even with a lower rate, refinancing only makes sense if you’ll meet your break-even point. For example, if your closing costs are $6,000 and refinancing reduces your monthly payments by $200, it’ll still take you 30 months to break even. If you plan on moving or refinancing again before 30 months, refinancing doesn’t make sense in this scenario.

Refinancing also doesn’t usually make much sense if you don’t have much equity in your home, your credit score has declined, or you already have a very low interest rate.

You should consult with a mortgage professional or financial advisor before deciding whether to refinance. And if you do refinance, be sure to compare multiple lenders to get the best rate and terms for your financial situation.

Disclaimer: The information provided in this article is for informational purposes only.  It is not intended as legal, financial, investment, or tax advice, and should not be relied upon as such.  Consult a licensed financial advisor or tax professional regarding your personal financial situation before making any decisions.