Takeaways
- Refinancing involves revising a loan's interest rates, term, or payments.
- Refinancing can increase monthly mortgage affordability and financial flexibility.
- Homeowners take advantage of refinancing when interest rates fall.
- Mortgage providers charge upfront fees and closing costs to refinance.
- You can refinance mortgages, personal loans, student loans, and business loans.
What Is Refinancing?
Refinancing is a financial strategy that replaces an existing mortgage with a new one to take advantage of better terms, such as a lower interest rate, altered repayment schedule, or a different loan type. When you refinance a loan, the new loan pays off the old one, and you start making payments under the new loan terms. Understanding how to refinance your mortgage can save you thousands of dollars.
According to a recent National Association of Realtors study, families spend an average of 26% of their income on mortgage payments. For first-time buyers, this jumps to nearly 40%.[1] Long-term mortgage affordability can be vital to financial success and stability. Considering all your options is a smart money move.
Most homeowners take advantage of falling interest rates by refinancing their mortgages. The main objective of refinancing is to lock in a lower interest rate on a new mortgage, which lowers the monthly mortgage payment and boosts home affordability.
Securing a lower interest rate allows you to pay a lower total interest over the life of your mortgage, allowing you to keep more of your hard-earned money. For this reason, refinancing is particularly beneficial for mortgages, where even a slight decrease in the interest rate can result in huge savings. Alternatively, you can also use refinancing to switch from an adjustable-rate mortgage to a fixed-rate mortgage.
If you think refinancing might be a money move, you can consult with your lender to determine your options. A thorough analysis will involve a review of your income, credit score, debt-to-income ratio, and other financial metrics. A lender will assess your application and determine your eligibility qualifying terms. From there, they will recommend a path forward. Once your application gets approved, the lender will pay off your current mortgage, and you will start repaying the new loan according to its terms.
Refinancing isn't free; it also comes with application fees, appraisal expenses, and closing costs. These fees can add up, so it is vital to calculate whether the long-term savings from a lower interest rate (or improved loan terms) outweigh the initial expenses. Some mortgage lenders provide tools, like plug-and-play spreadsheets or refinancing calculators, to help you weigh the benefits and costs of various scenarios.
What is Mortgage Refinancing?
Your home is an asset, and mortgage refinancing could be an excellent way to maximize its value. There are many reasons why you might want to consider refinancing your mortgage. For example, mortgage refinancing allows you to access cash from your home's equity, lower your monthly payments, or even shorten your loan term.
Get Smart: What Is a Home Equity Loan?
Refinancing your mortgage involves replacing your current mortgage with a new one with a different principal amount and a better interest rate. Mechanistically, the new loan pays off the old one and leaves you with a brand-new mortgage and monthly payment schedule. Mortgage refinancing also gives you the flexibility to add or remove someone from your mortgage, which can be helpful in particular personal or financial situations.
Learn More: Pros and Cons of a 30-Year-Fixed Rate Mortgage
However, mortgage refinancing does come with challenges. For example, the upfront cost to execute the refinancing can be high. These initial expenses are theoretically offset with future savings from lower monthly mortgage payments, but it is vital to understand when this breakeven point occurs.
Learn about other ways to lower your mortgage. Explore How to Recast Your Mortgage.
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How Refinancing Works
To start the refinancing process, contact your current lender (or find a new one) and fill out a new loan application. Your credit terms and overall financial health will be evaluated during the refinancing process.
Smart Tip:
You aren’t restricted to refinancing your primary residence. You can refinance second mortgages, auto loans, and student loans. Similarly, businesses might consider refinancing options for loans connected to commercial properties.
Refinance for better borrowing terms, especially when macroeconomic conditions shift in your favor. The main goals of refinancing usually involve:
- Lowering fixed interest rates
- Decreasing total interest payments
- Changing loan duration
- Switching between fixed-rate and adjustable-rate mortgages
You can also decide to refinance to take advantage of personal finance progress. For example, you can negotiate better terms if you have improved your credit score. Alternatively, through debt consolidation, you could adjust your long-term financial plans or streamline your existing debts into a single, lower, and more manageable loan.
Learn More: What Is the Federal Funds Rate?
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How Much Does Refinancing Cost?
According to Freddie Mac, refinancing a mortgage costs approximately $5,000 in closing fees.[2] The total cost can vary tremendously depending on the size of your mortgage, origination fees, and country or state.
Typically, you should anticipate paying between 2% - 5% of the new loan's balance in closing costs. For example, if you are refinancing a $200,000 mortgage, you might pay between $4,000 and $10,000 in closing fees.
5 Steps to Refinance Your Mortgage
Refinancing your mortgage involves several steps and coordination from multiple parties. Here is a closer look at how the refinancing process works:
1. Submission Application
You start by applying for a new mortgage with a lender of choice. This application will include detailed information about your financial status, income, credit score, and debts.
2. Credit and Financial Review
The lender will review your application and assess your financial situation thoroughly. This will involve checking your credit report, verifying your income, and evaluating your debt-to-income ratio. (Try Smart Money's Debt-to-Income Calculator.)
3. Loan Approval, Offer, and Appraisal
If you meet the lender's criteria, your loan application will be approved, and they will present you with a refinancing offer. This offer will detail the new loan's terms, including the interest rate, loan amount, and repayment schedule. Lenders typically require a home appraisal to determine your home’s market value.
4. Closing Process
The closing process begins once the appraisal is complete and mortgage terms are reached. You will need to sign several documents to finalize the new mortgage. This stage will also involve paying any associated closing costs.
5. Legacy Loan Payoff and New Monthly Payments
The mortgage provider lender will pay off your existing mortgage after closing. Your old loan is settled, and you will have a new loan with new terms. From there, you will make monthly payments on your new mortgage. These payments will reflect the latest interest rate, repayment schedule, and taxes.
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3 Alternatives to Refinancing
While refinancing can be a great financial move in certain situations, there may be a better alternative. Let's look at how you could improve home affordability without having to refinance your mortgage:
- Recast Your Mortgage: One of the main advantages of refinancing your mortgage is to reduce the total amount of interest expense paid over the life of your loan. An alternative to refinancing is to recast your mortgage. Recasting your mortgage involves making a large principal payment ($5,000 to $10,000 or more) and getting a new loan with the same terms. With a significantly reduced principal, you increase mortgage affordability and lower the amount of total interest paid.
- Eliminate PMI: Many lenders require Private Mortgage Insurance (PMI) when issuing conventional or jumbo loans when the borrower does not make a 20% down payment on the purchase price. However, once you have accrued 20% of home equity through mortgage payments, you can request to have your PMI terminated. This can significantly reduce your monthly mortgage payment and increase home affordability. Alternatively, many lenders will waive PMI once your loan-to-value reaches 78% or less.
- Downsize Homes: Your financial goals should dictate how much home you buy and what makes sense financially. If you are financially constrained, with your monthly mortgage payments eating the bulk of your discretionary income, consider selling your home. This could mean downsizing to a smaller house or simply downsizing your mortgage with a less expensive home. Finding a great real estate agent can help you get the best selling price. When pursuing new homes, consider getting a buyer’s agent to be your advocate.
Smart Summary
Refinancing can be an effective financing strategy to improve home affordability. Talk to your lender and explore how refinancing might improve your financial situation. Many lenders will provide pre-built refinancing payback calculators to calculate if refinancing makes sense for you. Refinancing isn’t the only option to improve your mortgage affordability. Consider recasting your mortgage, eliminating PMI, or downsizing your home. You want to own your home, not your home to own you. Consult with a financial advisor or your financial plan to ensure your mortgage payments marry with your long-term financial goals.
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(1) National Association of Realtors. More Than 90% of Metro Areas Recorded Home Price Increases in First Quarter of 2024. Last Accessed January 15, 2025.
(2) My Home by Freddie Mac. Costs of Refinancing. Last Accessed January 15, 2025.
