What is a mortgage refinance, and how does refinancing work?

Dan Green
The Mortgage Reports contributor

What does it mean to refinance a mortgage?

Refinancing is when a homeowner gets a new mortgage loan to replace their current loan.

Most people refinance to lower their interest rate and reduce their mortgage payments, often saving thousands in mortgage interest.

But that’s not the only reason to refinance a mortgage.

You can also refinance into a new loan type or a new loan term — which could help you pay off your house early. Or you could refinance to cash out home equity.

Verify your refinance eligibility (Nov 27th, 2021)

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How does refinancing work?

Refinancing involves taking out a new mortgage loan to replace your existing one.

When you refinance, you apply for a new home loan just as you did when you bought the house. But this time, instead of using the loan money to purchase a home, it’s used to pay off your existing mortgage.

Refinancing effectively erases the debt on your current mortgage. It also lets you choose the rate and loan terms on your new mortgage, so you can get a new home loan that saves you money or helps you accomplish other financial goals.

The result is that you continue to pay off your home — but now you’re making payments on the new loan instead of your old one.

Note, you don’t actually pay off the first mortgage yourself. The mortgage lender(s) involved handle that part on the back end.

As far as you’re involved, the mortgage refinance process typically looks a lot like your original home loan process did. 

Homeowners refinance because you get to choose the rate and loan terms on your new mortgage. So you can take out a new loan that’s more affordable or benefits you in another way (more on that below).

Verify your refinance eligibility (Nov 27th, 2021)

Home loan refinancing example

The most common reason to refinance is for a lower interest rate.

Say you bought a house two years ago. The house cost $300,000. You made a $30,000 down payment and took out a mortgage for $270,000 to cover the rest of the purchase price.

Now, interest rates have fallen, and you want to lock in a lower mortgage rate to reduce your monthly payments. So you decide to refinance.

  1. Your current loan balance with Lender A is $260,000
  2. You shop around and find out Lender B can offer you a lower interest rate than your current one
  3. You apply for a mortgage with Lender B, asking for a loan balance of $260,000
  4. You’re approved for the refinance loan
  5. Lender B uses the $260,000 to pay off your debt to Lender A
  6. Now you make monthly mortgage payments to Lender B
  7. You still have a $260,000 loan balance — but now you have a lower interest rate and cheaper monthly payments

Note, you don’t have to work with your current mortgage lender or loan servicer.

If the lender you used to buy your home can now offer you a lower rate and better terms, you’re free to refinance with your current lender.

But you’re also free to shop around for another company that can offer you an even better deal.

In fact, it’s highly recommended that you do so. Your finances have likely changed since you got your first mortgage — which means there’s a good chance your original lender is no longer your best bet.

How a mortgage refinance helps homeowners

Your personal finances are bound to change over the years. You’ll build home equity; your income may increase; maybe you’ll pay off debts and improve your credit score. 

As your finances improve, you’ll likely have access to better mortgage options than you did when you bought your home.

In addition, mortgage interest rates are constantly in flux.

If rates have fallen since you took out a home loan, there’s a good chance you can refinance to a lower rate and save — even if your finances look exactly as they did when you bought the house.

You can also change the features of your home loan when you refinance.

You can choose the number of years in your loan (your ‘loan term’); you can choose the nature of your interest rate (fixed-rate or adjustable-rate); and, you can even choose what you pay in mortgage closing costs.

Many homeowners refinance to get a lower mortgage rate. But a refinance mortgage can also help you pay your home off more quickly, eliminate mortgage insurance, or tap your home equity to pay off debt or fund home improvements.

Check your refinance options (Nov 27th, 2021)

3 types of refinance mortgages

Refinance mortgages come in three varieties — rate-and-term, cash-out, and cash-in. The refinance loan option that’s best for you will depend on your personal finances.

Refinance rates vary between the three types.

Rate-and-term refinance

A rate-and-term refinance lets homeowners change their existing loan’s mortgage rate, loan term, or both. Loan term is the length of the mortgage.

For example, a homeowner may refinance:

  • From a 30-year fixed-rate mortgage into a 15-year fixed-rate mortgage
  • From a 30-year fixed-rate mortgage with a 5% interest rate to a new 30-year mortgage with a 3% fixed rate
  • From a 30-year fixed-rate mortgage with a 5% interest rate to a 15-year fixed loan at 3%

The goal of a rate-and-term refinance loan is to save money. You do this either by getting a lower monthly payment, or paying less interest overall because of a lower mortgage rate or a shorter loan term.

If you refinance into a shorter loan term, your monthly payments will be higher. That’s because you’re paying off the same amount of money in a shorter amount of time.

But, since you’re eliminating years of interest payments, you save more money in the long run.

Most refinances are rate-and-term refinances, especially in a falling mortgage rate environment.

Cash-out refinance

The goal of a cash-out refinance is to tap your home equity.

Home equity is the portion of the home that you own. For instance, if your home is worth $300,000, and you owe $200,000 on your mortgage, you have $100,000 worth of home equity.

But equity isn’t liquid cash. To access it, you have to take a loan against the value of your home. That’s where a cash-out refinance comes in.

Remember that with a rate-and-term refinance, your new loan balance is equal to what you currently owe on the home, and it’s used to pay off your existing mortgage.

The difference with a cash-out refinance is that your new loan balance is bigger than what you currently owe.

The new loan is used to pay off your existing mortgage, and the money “left over” is the amount you’re cashing out.

Here’s a simple example of how cash-out refinancing works:

  • Home value: $300,000
  • Current loan balance: $150,000
  • New loan balance: $200,000
  • Cash received at closing: $50,000 (minus closing costs)

Because the homeowner owes only the original amount to the bank, the “extra” amount is paid as cash at closing. Or, in the case of a debt consolidation refinance, the cash-out is directed to creditors such as credit card companies and student loan administrators.

Cash-out mortgages can also be used to consolidate first and second mortgages when the second mortgage was not taken at the time of purchase.

In a cash-out refinance, the new loan may also offer a lower interest rate or a shorter loan term compared to the old loan. But the main goal is to generate liquid cash — so getting a lower interest rate isn’t required.

Cash-out mortgages represent more risk to a bank than a rate-and-term refinance mortgage, so lenders require more stringent approval standards.

For example, a cash-out refinance may be limited to a lower loan size as compared to a rate-and-term refinance; or, the cash-out refi may require higher credit scores at the time of application.

Most refinance loan programs also require borrowers to leave at least 15% to 20% of their home’s equity untapped. That means you won’t be able to withdraw all your home equity, but only a portion of it.

Verify your cash-out refinance eligibility (Nov 27th, 2021)

Cash-in refinance

Cash-in refinance mortgages are the opposite of cash-out refinancing.

With a cash-in refinance, the homeowner brings cash to closing in order to pay down the loan balance and lower the amount owed to the bank. This may result in a lower mortgage rate, a shorter loan term, or both.

There are several reasons why homeowners choose the cash-in mortgage refinance process.

The most common reason is to get lower interest rates which are available only at lower loan-to-value ratios (LTVs).

LTV measures the size of the loan in comparison to the home’s value. A loan with an 80% LTV, for example, will often charge higher interest rates than a loan at 75% LTV

Another common reason to cash-in refinance is to cancel mortgage insurance premium (MIP) payments.

When you pay your conventional loan down to 80% LTV or lower, your private mortgage insurance premiums (PMI) are no longer due.

This rule does not apply to FHA loans, which typically require mortgage insurance premiums (MIP) throughout the life of the loan.

However, a homeowner could replace an existing FHA loan with a conventional loan through the refinance process. This strategy could eliminate mortgage insurance premiums and help you save even more month-to-month.

The mortgage refinance process

When you get a mortgage refinance loan, you are establishing a brand-new home loan with brand-new terms. This typically means you must go through the full mortgage application and approval process.

Mortgage underwriters will evaluate your application in three specific areas:

  1. Credit score and credit history
  2. Income and employment history
  3. Assets and cash reserves

Your home will also be appraised to confirm its current market value, just as it was when you got your existing loan.

Despite the similarities between buying and refinancing, borrowers can usually expect to provide less documentation during the refinancing process.

You will still be asked to provide proof of income using W-2s and pay stubs; proof of assets via bank statements; and proof of citizenship or U.S. residency status.

But you will not be asked to provide information related to the original transfer of the home.

Refinance mortgages are often ready to close in 30 days or fewer.

But keep in mind that market conditions can affect closing times. If rates have fallen sharply and many homeowners are rushing to refinance at the same time, it may take 40-45 days or longer to close.

Low-doc refinance programs

Refinance lenders normally need to verify your income, assets, and credit history. But some refinance programs let you bypass this verification process.

These programs are called Streamline Refinances. They’re ‘streamlined’ because underwriting requirements are simplified and designed to be speedy.

With a Streamline Refinance, mortgage lenders waive large parts of their “typical” refinance mortgage approval process.

Often, home appraisals, income verification, and credit score checks are all waived.

Homeowners may have access to a Streamline Refinance loan if their current mortgage is backed by the federal government — including FHA loans, VA loans, and USDA loans.

Although different lenders may set their own requirements (sometimes including appraisals and credit approval), the general guidelines for Streamline Refinancing are as follows. 

FHA Streamline Refinance

The FHA Streamline Refinance is available to homeowners with an existing FHA mortgage. This refinance program waives credit and income verification and does not require a home appraisal.

FHA refinance rates are generally low. But homeowners will have to pay for upfront mortgage insurance and annual mortgage insurance premiums (MIP), just like with an FHA home purchase loan. These added costs will impact your refinance savings.

To qualify for the FHA Streamline program, you must have a history of on-time mortgage payments. And a “net tangible benefit” is required — meaning the refinance mortgage will have a significantly lower rate and/or payments than your current loan.

Cash-out refinance mortgages are not allowed via the FHA Streamline Refinance program.

FHA does back a cash-out refinance loan, but it requires full underwriting and typically has higher credit score requirements.

Verify your FHA refinance eligibility (Nov 27th, 2021)

VA Streamline Refinance (IRRRL)

The VA Streamline Refinance is available to homeowners with an existing VA-backed mortgage.

Officially known as the VA Interest Rate Reduction Refinance Loan (IRRRL), the VA Streamline Refinance also waives income, asset, and credit score verifications.

Refinancing VA homeowners are required to show the refinance mortgage will result in monthly payment savings, except for homeowners changing to a shorter loan term, such as from a 30-year loan to a 15-year loan; or, from an adjustable-rate mortgage to a fixed-rate loan.

Homeowners may not receive cash-out as part of a VA Streamline Refinance.

Verify your VA IRRRL eligibility (Nov 27th, 2021)

USDA Streamline Refinance

The USDA Streamline Refinance Program is available to homeowners with existing USDA home loans. USDA loans, designed for homeowners in rural or suburban areas, allow up to 100% financing.

The USDA Streamline Refinance Program does not verify income, assets, or credit. And homeowners using the program to refinance are limited to 30-year fixed-rate mortgages; ARMs are not allowed.

Cash-out refinance mortgages are not allowed via the USDA Streamline Refinance.

Verify your USDA refinance eligibility (Nov 27th, 2021)

Fannie Mae’s High-LTV Refinance Option (HIRO)

Fannie Mae’s High LTV Refinance Option (HIRO) allows homeowners with little, no, or even negative home equity to get a new loan at today’s lower interest rates.

Only homeowners with conventional loans backed by Fannie Mae can qualify for this refinancing option, and your current loan’s origination date must be on or after October 1, 2017.

The HIRO program also requires borrowers to have six months of on-time monthly payments on their current loan and no more than one late payment in the past year.

And you’ll need a clear benefit to your refinance loan — a lower monthly payment, a shorter loan term, or replacing an adjustable-rate mortgage with a fixed-rate loan.

Verify your refinance eligibility (Nov 27th, 2021)

Refinance loan FAQs

How do I know if a refinance loan will save money?

Getting a new loan with a shorter term or a lower interest rate should save you money.

However, these savings can play out in different ways. A shorter loan term, for example, can save money in total interest paid to the lender over the life of the loan. But the shorter repayment period typically requires higher monthly mortgage payments.

Also, most refinance loans require closing costs which normally add about 3% of the loan amount due upfront. You should measure these costs against the savings your new loan can provide.

A refinance calculator can help you compare these current costs and ongoing savings.

Can I access home equity without refinancing?

Your home equity refers to the value you’ve built up in your home by paying down your current loan balance and through your home’s appreciation in value over time.

A cash-out refinance, described above, can help you tap into this value and get a lower interest rate at the same time. But you can also access your equity without replacing your current loan.

A home equity loan or a home equity line of credit (HELOC) borrows against your home’s equity while keeping your current mortgage loan intact. If you’re happy with your current home loan’s rate and term, one of these ‘second mortgage’ options may be best for your financial situation.

I already have a second mortgage. Can I still refinance?

Yes. A refinance loan could pay off your first and second mortgages, replacing them with a single loan. If you have a HELOC or home equity loan you may choose to keep it while refinancing only your first mortgage. Be sure to tell your loan officer about your HELOC as you begin the refinancing process.

The lender will need to ‘subordinate’ the second mortgage under the new first mortgage. The subordination process can take time depending on the second mortgage lender. So ask your lender to start this process early in your refinance.

Is it ever too late to refinance an existing loan?

You can refinance your old loan at any point, but your opportunity to save is typically greater on newer mortgage loans.

For example, if you’re 20 years into a 30-year loan, you’ve already paid most of the loan’s interest. Restarting your mortgage with a new 30- or 15-year term would likely cost you a lot more in the long run. Although, some lenders offer a 10-year mortgage term, which in this case could be a good solution. 

If you’re only two years into the same 30-year loan, a lower interest rate or shorter loan term could save a significant amount over the life of the loan.

Can I save money on a mortgage without refinancing?

A homeowner whose existing loan already has a competitive interest rate can still save by paying extra on the principal balance. You’d make your scheduled monthly payment, then pay an additional amount directly toward the loan’s principal balance.

Making regular direct-to-principal payments shortens the life of the loan and reduces your loan’s overall interest charges. This strategy can mimic a shorter mortgage term without requiring the closing costs and the underwriting hassles associated with an entirely new loan.

Can I refinance even if I have bad credit?

It’s possible to refinance with a credit score as low as 580 using an FHA loan. But you need to consider your current mortgage before making this decision.

It’s likely a good idea to refinance if you already have an FHA loan and an FHA refinance can net you a lower interest rate. But if your score has fallen since you took out your original mortgage, and you’d be bumped from a conventional loan to an FHA loan with expensive mortgage insurance, refinancing might not be worth it.

f your current mortgage is a government-backed FHA, VA, or USDA loan, you may be able to refinance without a credit check via the Streamline Refinance program. In this case, it wouldn’t matter if you have ‘bad’ or ‘fair’ credit — you could lower your interest rate regardless of credit score as long as your lender judges you by written rules of the program.

Can I refinance a jumbo loan?

You can refinance a jumbo loan, but you should expect more stringent underwriting standards compared to conforming and government-backed loans. Many lenders require jumbo loan borrowers to have a credit score of 660 or above and debt-to-income ratio at or below 43%. You may also be asked to show you have enough cash to make a couple years’ worth of house payments if necessary.

If you’re struggling to make payments on a jumbo loan but can’t qualify for a refinance, ask your loan servicer about loan modifications.

Should I buy discount points when I refinance?

Just like with your original home loan, buying discount points can save money long-term if you keep the refinanced loan long enough. But points can add a significant amount to your refinance closing costs. So you need to consider whether the amount you’d save via a lower interest rate outweighs the cost of buying points within the time you plan to keep the loan.

Today’s mortgage refinance rates

There are many ways to refinance a home and millions of U.S. homeowners are potentially eligible for lower rates and payments.

The best way to find your low rate is to shop with three to four different lenders and compare offers.

Verify your new rate (Nov 27th, 2021)