How Does Mortgage Refinancing Work?

How Does Mortgage Refinancing Work?

Fundamental mortgage Q&A: “How does mortgage refinancing work?”

When you refinance your mortgage, you are essentially trading in your old loan for a fresh one with a new interest rate and mortgage term. And possibly even a new loan balance.

You may elect to receive this new mortgage from the same bank that held your old loan previously, or you may refinance your home loan with an entirely different lender.

It’s certainly worth your while to shop around if you’re thinking about refinancing your mortgage, as your current lender may not have the best deal.

I’ve seen first-hand lenders try to talk their existing customers out of a refinance simply because there wasn’t an incentive for them. So be careful when dealing with your current lender.

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Regardless, the bank or mortgage lender that ultimately grants you the new mortgage essentially pays off your old mortgage with a new mortgage, thus the term refinancing. You are basically redoing your loan.

In a nutshell, most borrowers choose to refinance their mortgage either to take advantage of lower interest rates or to cash in on equity accrued in their home.

Two Main Types of Mortgage Refinancing

mortgage refinancing

There are two main types of refinancing; rate and term and cash-out (click the links to get in-depth explanations of both).

Let’s start with the most basic mortgage refinance, which is the rate and term refinance. If you don’t want any cash out, you’ll simply be looking to lower your interest rate and possibly adjust the term of your existing mortgage.

Rate and Term Refinancing

  • Loan amount stays the same
  • But the interest rate is reduced
  • And/or the loan product is changed
  • Such as going from an ARM to a FRM
  • Or from a 30-year fixed to a 15-year fixed

Let’s look at an example:

Original mortgage: $300,000 loan balance, 30-year fixed @ 6.25%
New mortgage: $300,000 loan amount, 15-year fixed @ 4.50%

Put simply, a rate and term refinance is basically the act of trading in your old mortgage(s) for a new shiny one without raising the loan amount. As noted, the motivation to do this is to lower your rate and possibly shorten the term in order to save on interest.

In my example above, the refinancing results in a shorter-term mortgage and a substantially lower interest rate. Two birds, one stone.  It will be paid off faster and with far less interest.  Magic.

Here’s a more in-depth example with monthly payments included:

Loan amount: $200,000
Existing mortgage rate: 6.5% 30-year fixed
Existing mortgage payment: $1,264.14
New mortgage rate: 3.25% 15-year fixed
New mortgage payment: $1,405.34

In this scenario, you’ll notice that your loan amount remains unchanged because it’s merely a rate and term refinance, but your interest rate drops and your mortgage term is also reduced from 30 years to 15 years.

At the same time, your monthly mortgage payment increases nearly $150. While this may seem like bad news, it’ll mean much less will be paid in interest over the shorter term and the mortgage will be paid off much quicker. We’re talking half the time.

For those who don’t want a mortgage hanging over their head for 30 years, this use of a rate and term refinance can be a good strategy. Especially since the big difference in rate barely increases the monthly payment.

But you don’t need to reduce your term to take advantage of a rate and term refinance. You can simply refinance from one 30-year fixed into another 30-year fixed, or from an adjustable-rate mortgage into a fixed mortgage to avoid a rate reset.

If you’re keeping your term the same, the refinance will serve to lower monthly payments, which is also a common reason to refinance a mortgage. Simply to pay less each month if you’re short on funds, or to put your money to work elsewhere, such as in another investment.

So there are plenty of options here – just be sure that you’re actually saving money by refinancing, as the closing costs can eclipse the savings if you’re not careful.

As you can see, Reasons for carrying out this type of refinancing include securing a lower interest rate, moving out of an adjustable-rate mortgage into a fixed-rate mortgage (or vice versa), going from an FHA loan to a conventional loan, or consolidating multiple loans into one. And in our example, to reduce the term as well (if desired).

See many more reasons to refinance your mortgage, some you may have never thought of.

Lately, a large number of homeowners have been going the rate and term refi route to take advantage of the unprecedented record low mortgage rates available.

Many have been able to refinance into shorter-term loans like the 15-year fixed mortgage without seeing much of a monthly payment increase thanks to the sizable rate improvement.

Obviously, it has to make sense to the borrower to execute this type of transaction, as you won’t be getting any cash in your pocket (directly) for doing it, but you will pay closing costs and other fees that must be considered.

So be sure to find your break-even point before deciding to refinance your existing mortgage rate.  This is essentially when the refinancing costs are “recouped” via the lower monthly mortgage payments.

If you don’t plan on staying in the home/mortgage for the long-haul, you could be throwing away money by refinancing, even if the interest rate is significantly lower.

 

Cash-Out Refinancing

  • The loan amount is increased
  • As the result of home equity being tapped
  • The cash can be used for any purpose
  • May also result in a lower interest rate and/or product change
  • But monthly payment may increase as a result of the larger loan amount

Original mortgage: $300,000 loan balance, 30-year fixed @6.25%
New mortgage: $350,000 loan amount, 30-year fixed @4.75%

Now let’s discuss a cash-out refinance, which involves exchanging your existing home loan with a larger mortgage in order to get cold hard cash.

This type of refinancing allows homeowners to tap into their home equity, assuming they have some, which is the value of the property less any existing mortgages or liens.

Let’s pretend the borrower from my example has a home that is now worth $437,500, thanks to a mix of mortgage payments and healthy home price appreciation.

That would allow them to pull $50,000 out of their home while keeping their new mortgage at that all-important 80% loan-to-value (LTV).

This cash out amount is added to the existing loan balance of $300,000, giving them a new loan balance of $350,000. What’s really cool is the mortgage payment would actually go down by about $25 in the process because of the large difference in interest rates.

So even though the borrower took on more debt via the refinance, they’d actually save money each month relative to their old loan payment.

Now a more in-depth example:

Loan amount: $200,000
Existing mortgage rate: 6.5% 30-year fixed
Existing mortgage payment: $1,264.14
Cash out amount: $50,000
New loan amount: $250,000
New mortgage rate: 4.25% 30-year fixed
New mortgage payment: $ 1,229.85

In this scenario, you’d refinance from a 30-year fixed into another 30-year fixed, but you’d lower your mortgage rate significantly and get $50,000 cash in your pocket (less closing costs).

At the same time, your monthly mortgage payment would actually fall $35 because your former interest rate was so high relative to current mortgage rates.

While this all sounds like good news, you’ll be stuck with a larger mortgage balance and a fresh 30-year term on your mortgage.

So if you’re looking to pay off your mortgage in full some day soon, this isn’t the best move. But if you need cash for something, whether it’s for an investment or to pay off other more expensive debts, this could be a worthwhile decision.

In short, cash out refinancing puts money in the pockets of homeowners, but has its drawbacks because you’re left with a larger outstanding balance to pay back as a result (and there are also the closing costs, unless it’s a no cost refi).

While you wind up with cash, you typically get handed a higher monthly mortgage payment in most cases.  In our example, the monthly payment actually goes down thanks to the substantial rate drop, and the homeowner gets $50,000 to do with as they please.

While that may sound great, many homeowners who serially refinanced over the past decade have found themselves underwater, or owing more on their mortgage than the home is currently worth, despite buying properties on the cheap years ago.

This is why you have to practice caution and moderation. For example, a homeowner might pull cash out and refinance into an ARM, only for home prices to drop and zap their remaining equity, leaving them with no option to refinance again if and when the ARM adjusts higher.

That being said, only pull cash out when absolutely necessary because it has be paid back.  And it’s not free money. You must pay interest and closing costs so make sure you have a good use for it.

Refinance Mortgage Rates

  • If your loan is simply a rate and term refinance
  • Your interest rate shouldn’t differ from that of a home purchase loan
  • But if you request cash out with your refinance
  • Additional pricing adjustments will likely apply and increase your interest rate, perhaps substantially

Now let’s talk about refinance mortgage rates for a moment. When filling out a loan application or a lead form, you’ll be asked if it’s a purchase or a refinance. And if it’s the latter, if you want additional cash out.

For most lenders, a home purchase and rate and term refinance will be treated the same in terms of interest rates. There shouldn’t be additional pricing adjustments just because it’s a refinance.

In fact, refinances are actually less risky than home purchases because they involve existing homeowners who are typically lowering their monthly payments or switching from an ARM to a fixed-rate loan product.

Don’t expect a discount though, just be happy there isn’t an add-on cost for it not being a purchase.

When it comes to cash-out refinances, there are typically additional pricing adjustments that increase the interest rate you will ultimately receive.

This means instead of receiving a 4% mortgage rate, you may be stuck with a rate of 4.25% or higher depending on the loan scenario.

If you have a low credit score, a high LTV, and want cash out, your mortgage rate could skyrocket, as the pricing adjustments are quite hefty with that combination.

Additionally, qualifying for a cash-out refinance will be more difficult because the larger loan amount will raise your loan-to-value ratio and put increased pressure on your debt-to-income ratio.

In summary, be sure to do the math and plenty of shopping around to determine which type of refinance is best for you.

Refinancing Your Mortgage May Not Be Necessary

  • It’s not always the right move
  • Depending on your current situation
  • And your future plans
  • So make sure it makes sense first

Despite what the banks and lenders might be chirping about, refinancing isn’t always the winning move for everyone. In fact, it could actually cost you money if you don’t take the time to crunch the numbers and map out a plan.

If you’re not sure you’ll still be in your home next year, or even just a few years from now, a refinance might not make sense if you don’t recoup the associated costs.

Instead of borrowing more than you need, or “resetting your mortgage,” do the math first to determine the best move for your unique situation.

My refinance calculator might be helpful in determining what makes sense depending on the situation in question.

One alternative to refinancing your existing home loan is to instead take out a second mortgage, often in the form of a home equity line of credit.

This keeps the first mortgage intact if you’re happy with the associated interest rate and loan term, but gives you the power to tap into your home equity (get cash) if and when necessary.

But as we saw in my example above, it’s sometimes possible to get a lower mortgage payment and cash out at the same time, which is hard to beat. Just remember to factor in the cost of the refinance.

Read more: When to refinance your mortgage.


17 Comments

  1. Karen March 24, 2018 at 11:37 am -

    I moved in with my Son in 2004 and he and his wife moved out a couple of months later. Since 2004 I have been making the mortgage payments. Accountant has allowed me to claim the mortgage interest. I now need to refinance this loan. I am not on title and have not officially assumed the mortgage. Can I “refinance”. Do not want to purchase because of tax reasons for my Son and because I don’t want to come up with 20% down. What are my options?

  2. Colin Robertson September 8, 2017 at 2:42 pm -

    Eddie,

    You may not get the full $22k because of closing costs, such as the funding fee, which may be deducted from your proceeds. Though a lender credit could potentially be used to offset those costs in exchange for a higher interest rate.

  3. Eddie R. September 8, 2017 at 5:51 am -

    Colin,

    We currently have VA 30yr fixed loan. The original loan was ~$69,000 and currently own ~$63,000 and the value of our home I believe is ~$85,000. We are looking to do the cash out refinancing option( mainly for repairs). From my understanding, that give us $22,000 cash on hand and a new loan of $85,000 and a lower rate(current rates). It that correct? Also is there any upfront cost or closing cost for refinancing a VA loan?

  4. Colin Robertson August 8, 2017 at 6:52 am -

    Denis,

    Would be with the local tax assessor to challenge the value of your home and therefore lower your tax bill. Not through the lender.

  5. Denis Plug August 7, 2017 at 10:32 am -

    How do you dispute taxes? Is it that the property value went up, hence an increase in taxes? Just shopped for insurance and got a higher quote.

  6. Latarsha August 3, 2017 at 5:57 pm -

    This happens because either your taxes and/or insurance is going up and they want to make sure it is enough in your escrow to cover it. This has happen to me with our mortgage. You can dispute your taxes and maybe find a cheaper insurance company.

  7. Colin Robertson July 7, 2017 at 12:11 pm -

    Connie,

    If you don’t trust Wells, you could shop around and see what other banks/lenders are able to offer.

  8. Connie Rondeau July 1, 2017 at 9:17 am -

    Wells Fargo keeps saying they need it for escrow. Lately I’ve not been hearing good things about Wells Fargo either. It leaves me wondering if a refinance might be a good option

  9. Colin Robertson June 20, 2017 at 8:27 am -

    Connie,

    It depends why the payment is going up…is it an ARM? If so, it might be possible to refinance into a fixed loan and avoid payment increases going forward. But as mentioned, it might be going up for a different reason, such as taxes and insurance going up. Once you know why, you can act accordingly.

  10. Connie Rondeau June 20, 2017 at 6:22 am -

    I meant the monthly payment keeps going up, it started at 472/month and is now over 500/month, and I don’t think that’s the end of it either. I’m wondering if refinancing would be the way to go as I’ve only got my checks to depend on since my husband’s death earlier this year

  11. Colin Robertson June 19, 2017 at 9:42 pm -

    Connie,

    Raising the payment or the rate? Escrow might require more money each month to go toward taxes and insurance. Refinancing means to take your loan elsewhere, ideally to get a lower interest rate…and yes, there is typically an option to refi without any out-of-pocket expenses, though they are baked into the loan instead.

  12. Connie Rondeau June 17, 2017 at 4:23 am -

    I got my loan on VA, but the bank keeps raising the rate saying they need to for the escrow. I’d like to refinance for a lower monthly payment. How would that work and would I have to pay anything up front to refinance?

  13. Colin Robertson June 5, 2017 at 10:12 am -

    Linda,

    Basically if you refinance just your existing balance you’d maybe have an LTV around 67.5% ($162k/$240k). If you decided to get some cash as well, it would be added to your outstanding balance. Say you took $18k cash, it’d be roughly a $180k loan amount, or 75% LTV when divided by $240k. Potentially you could borrow up to $192k if the lender valued the home at $240k, keeping the LTV at 80% or less to drop MI. Your new payment would be based on whatever loan amount you choose, factoring in the new mortgage rate and loan term. So the payment could increase but it depends what you do and what rate you obtain via the refinance. And yes, closing costs can likely be included or paid by a lender credit so no cash has to come out of pocket.

  14. Linda Cathey June 4, 2017 at 11:15 pm -

    Had loan for 33 months. Original cost of home $187,500. less 10% down; 30 year loan for $168,750 @ 4.5%. Current balance $162,000. Total payment including taxes and insurance is $1045 monthly. Current value of home $240,000. Fixed income senior citizens, have $8,500 in credit card debt (one account only – no interest until 2018 – pay $150 mo) + 42 months left on auto loan ($415 mo). $1000 in savings and 825 credit score. Would like to refinance to get rid of $55 monthly PMI. And possibly some cash out to pay off credit card debt and have some savings. Annual income is $63,000; no investments. Would it be advisable to do this and would we encounter difficulty qualifying in our current financial situation? I do not understand how cash out refi works. What principle balance would we need to finance to accomplish this and how much would our payment increase? Would it be better to just refi the current balance at a little lower rate? Would PMI drop off? Could closing costs be included in the loan?

  15. Brett Wood October 8, 2015 at 8:02 pm -

    In regards to a HELOC vs a refinance: I would caution anyone against using your equity to extend a line of credit. HELOC rules change often and come with an acceleration clause meaning a bank can call the amount due in full at any time if they choose. They also have relatively shorter term limits and some turn into a fixed second mortgage upon term completion. This option should really only be used by farmers and the like who need the money upfront but, can reasonably expect to pay off the money drawn out relatively quickly. An example would be the farmer takes out a HELOC for farm equipment and after harvest, pays it off in full.

  16. Colin Robertson February 24, 2015 at 10:20 am -

    Josh,

    Yes, the remaining balance of the loan would be paid off via the refinance and your new loan would take on that balance. So after 15 years on a $300k, 30-year mortgage you might have $200k or so remaining. This amount would be paid off via the refi and a new loan for around $200k would be created. Of course, one could also add cash-out on top of that amount too, in which case the loan would be bigger. But that’s optional.

  17. Josh February 24, 2015 at 9:59 am -

    When you refinance, you’ll just be paying off the remaining balance on the mortgage and not starting over completely from scratch, right? For example, if you’re mortgage was for $300,000 15 years ago, and you’ve paid off say, half of that. Then would you just be refinancing the remaining half, instead of paying back the original $300,000?

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