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How Does Refinancing Work (And When It Makes Sense)

FHA Cash-Out Refinance: Turn Your Home Equity Into Cash

Mortgage rates reached historic lows in 2020, and mortgage refinances skyrocketed. Freddie Mac reported that in the fourth quarter of 2020, borrowers who refinanced their mortgage were able to reduce their interest rate by more than 1.25 percentage points.

Given this, you may wonder whether refinancing your mortgage is a good option. But how does refinancing work? If you aren’t sure if refinancing is right for you or where to start, this guide can help you understand the process and make an informed decision.

In this article

  • How does refinancing work?
  • Why do people choose to refinance their mortgage?
  • What types of mortgage refinances are available?
  • What is the mortgage refinancing process like?
  • FAQs
  • Bottom line

How does refinancing work?

When you refinance a home loan, you work with a mortgage lender to take out a new loan and use it to pay off your existing one. The new mortgage could have a different term, interest rate, or monthly payments.

When you refinance your loans, you’re essentially going through the mortgage process again, which means you’ll typically have to pay closing costs. However, that expense could be worth it, depending on the benefits you might get from refinancing your mortgage.

Why do people choose to refinance their mortgage?

So why might refinancing your mortgage be a good idea? It could give you one or more of the following benefits:

1. Reduce monthly mortgage payments

When you refinance your mortgage, you can work with your lender to choose a new loan term. If you want to get a lower monthly payment to free up more money in your budget each month, you could opt for a longer loan term.

For example, you could switch from a 15-year to a 30-year loan. You may pay more in interest over time due to the longer repayment term, but you might get a much smaller payment than you have now. You could use the additional money in your budget to cover everyday expenses, save for a large purchase, or invest for retirement.

2. Access a lower interest rate loan

Depending on when you took out your mortgage and your creditworthiness, your current mortgage could have a relatively high interest rate. For example, rates on 30-year fixed-rate mortgages were as high as 4.94% in November 2018.

According to Freddie Mac, the average interest rate on 30-year fixed-rate mortgages was just 2.77%, whereas the average rate on a 15-year fixed rate was 2.10%, as of Aug. 13, 2021. If you have good credit and refinance your mortgage, you might be able to take advantage of the low rates and potentially pay significantly less interest over the life of your loan.

For example, let’s say you took out a $250,000 mortgage in 2018 at 4.94% with a 30-year term. If you refinanced and qualified for a 30-year mortgage at 2.77% interest, your monthly payment would drop by $358. Even after deducting the expense of closing costs and an additional three years of payments, you’d save nearly $74,000 over the life of the loan.

If you went with a 15-year refinance instead and got a 2.10% rate, your monthly payments would be slightly higher, but you’d save nearly $150,000 in interest with the shorter term.

Original 30-year mortgage Refinanced 30-year mortgage Refinanced 15-year mortgage
Years remaining 27 30 15
Closing costs N/A $7,000 $7,000
Minimum monthly payment $1,333 $978 $1,549
Total interest paid $196,000 $113,000 $40,000
Total principal paid $239,000 $239,000 $239,000
Total cost $435,000 $359,000 (including closing costs) $286,000 (including closing costs
Total savings ~$76,000 ~$149,000

Keep in mind that the lowest rates the lenders offer are typically for borrowers with excellent credit, steady incomes, and low debt-to-income ratios. Not everyone will qualify for the lowest advertised rates.

3. Get cash for home improvements or other financial needs/goals

If you’ve built equity in your home, you could refinance your mortgage and tap into that equity to pay for your child’s college education, pay off your credit card debt, renovate your home, or for other expenses.

With a cash-out mortgage refinance, you could apply for a new loan for more than you currently owe. If approved, you’ll receive the difference between the new mortgage and your old one as a lump-sum cash payment to use as you wish.

What types of mortgage refinances are available?

There are a few different types of mortgage refinance available, and your financial goals and your existing loan type will help to determine which option works best for you. Depending on your situation, you may be able to take advantage of one of the following loan options:

Traditional refinance

Best for: Borrowers who have relatively high interest rates on existing mortgages

With traditional refinancing, also known as no-cash-out refinancing, you apply for a new loan to replace your existing one. You only get a loan for the amount you currently owe, and you only modify the loan term or interest rate. For instance, you might refinance a 30-year mortgage to a 15-year loan or an adjustable-rate mortgage to a fixed-rate loan.

For traditional mortgage refinancing closing costs, you might expect to pay around 3% to 6% of your outstanding principal in refinancing fees, though this can vary by lender. On a $250,000 mortgage, that means you should plan on saving up between $7,500 and $15,000 for closing costs.

As with your original mortgage, refinancing closing costs cover expenses like your home appraisal, origination fees, application fees, inspections, and attorney fees. In some cases, you might be able to roll these costs into the new loan amount.

Cash-out refinance

Best for: Borrowers who need cash for home improvements or other major expenses

With a cash-out refinance loan, you apply for a loan that is larger than what you owe on your current mortgage. After paying off your current loan, the lender gives you the difference between the mortgage amounts in cash. You can use the money from a cash-out refinance for any needs you may have, such as financing home improvement projects or paying for a wedding.

Although a cash-out refinance loan can give you access to low-interest cash, it does reduce your equity because you’ll have a larger loan going forward. Because of the higher mortgage balance, you might also pay more interest charges over time than if you kept your original mortgage. But this will depend on both the interest rate on your old mortgage and your new one.

Cash-out refinances generally have similar closing costs to traditional mortgage refinances, so you might expect to pay 3% to 6% of your loan’s amount. Again, this might vary depending on the lender you work with, and you might be able to roll costs into your new loan.

If you need to finance a large expense, refinancing isn’t the only way to get money from your home’s equity. You could also take out a second loan against your property. Check out our articles on cash-out refinance vs. home equity loan and HELOCs vs. home equity loans to compare options.

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Cash-in refinance

Best for: Borrowers who want to eliminate private mortgage insurance (PMI)

To qualify for refinancing, you typically need at least 20% equity in your home. If you’re not there yet but you’re interested in eliminating your private mortgage insurance, you might consider a cash-in refinance loan. With this approach, you make a lump-sum payment when you refinance, reducing your mortgage amount. The lump-sum payment will help you reach the 20% equity required, and if your home’s loan-to-value ratio reaches 78% or less, you could eliminate private mortgage insurance.

In addition to the lump-sum payment, you’ll likely have to pay closing costs on the new mortgage amount. Although closing costs can vary by lender, you can generally expect to pay 3% to 6% of your new loan’s balance. Consider asking your lender whether it makes sense to roll these costs into your new loan balance.

Streamline refinance

Best for: Borrowers with low credit scores

If you have a poor to fair credit score — meaning a score of 669 or lower — it can be challenging to qualify for certain refinancing loans. However, you may be eligible for a streamline refinancing loan, which is a type of loan that’s backed by the government.

There are multiple kinds of streamline refinancing:

  • FHA: With U.S. Federal Housing Administration streamline refinancing, you could potentially get a more affordable mortgage. There are no income requirements for this type of loan, and some lenders issue non-credit qualifying loans with no credit check needed as well. To qualify, you must have an existing FHA loan.
  • VA: If you have a mortgage backed by the Department of Veterans Affairs, you could use an interest rate reduction refinance loan to get a lower rate or switch your mortgage from an adjustable-rate loan to a fixed-rate loan.
  • USDA: The U.S. Department of Agriculture streamlined refinance loan program could help qualifying borrowers with low or no equity. No credit check is required, and there are no home inspections or appraisals. The program promises at least a $50 reduction in monthly principal, interest, real estate taxes, and homeowners insurance payments as compared with your old mortgage.

Closing costs can vary by program and lender. If you have questions, talk to your mortgage lender about costs and your options.

What is the mortgage refinancing process like?

If you want to refinance an existing mortgage and are wondering how to get a loan, follow these steps:

1. Think about your goals

At the beginning of the refinance process, spend some time thinking about what you’re looking to accomplish by refinancing your old loan. For example, you may want to get a lower rate to save money, get cash for debt consolidation or major expenses, or switch your mortgage to a fixed-rate loan. By setting a goal, you can better compare lenders’ rates and terms to find the best option.

2. Get quotes from different lenders

To ensure you get the best rates possible, consider comparing refinance options and getting quotes from multiple lenders. Make sure you ask the lenders about any added fees and closing costs and whether you can roll them into your new mortgage amount.

3. Select a lender

Once you’ve reviewed quotes from several lenders and are clear on what fees are involved, you can select a lender and apply to refinance your mortgage. The lender will work with you to complete a home appraisal, and underwriters will review and verify your information.

You’ll likely be asked to provide documentation of your income, expenses, and assets. For example, a lender may ask for the following:

  • Proof of income, such as pay stubs, W-2 forms, or tax returns
  • Government-issued identification
  • Current bank and investment account statements
  • Property records
  • Estimates of annual property taxes, homeowner association fees, and homeowners insurance policies
  • Profit and loss statements, if self-employed
  • Payment history for utility bills
  • Statements for outstanding debt, such as student loans or auto loans
  • Credit explanation letters for late payments or other derogatory marks on your credit report

4. Close on the loan

After the loan is approved, your home is appraised, and your information is verified, you can close on the loan. This step could take several weeks or even months. In the latest Ellie Mae Origination Insight Report, researchers found that the average time to close for mortgage refinancing was 48 days as of June 2021, the most recent available data.

Until you receive a notification from the refinancing lender that your new loan has been disbursed and your previous mortgage settled, keep making your current payments to avoid costly late fees or damage to your credit score.


Does refinancing your mortgage hurt your credit score?

In general, refinancing your mortgage could impact your credit in two ways:

  • New hard inquiries: A new hard inquiry on your credit reports could cause a small dip in your credit score. In general, new credit inquiries might reduce your score by about five points.
  • Payment history: Establishing a positive payment history on your new mortgage loan could help increase your credit score over time.

Can you refinance with bad credit?

Credit requirements for mortgage refinancing can vary by lender. However, you’ll generally need a score of 620 or higher to qualify for refinancing with most banks, credit unions, or online lenders.

Some government programs allow you to refinance with a score as low as 580, and certain ones might not require a credit check at all. Talk to a lender that’s approved by the Department of Housing and Urban Development (HUD) to discuss your options.

Do you lose equity when you refinance?

Whether or not you lose equity when you refinance depends on if you opt for a traditional refinance, cash-out refinance, or cash-in refinance.

With traditional refinancing and cash-in refinancing, your equity could stay the same or even increase. However, you might lose equity if you add your closing costs to your loan amount because that increases your total mortgage loan.

With a cash-out refinance, you will likely lose some equity because you’re increasing how much you owe on your mortgage.

Can you drop private mortgage insurance if you refinance?

If you’ve built up enough equity in your home, you could potentially refinance and eliminate PMI from your mortgage. If you don’t have enough equity established yet, you could choose to use a cash-in refinance and make a large payment when you refinance. Doing so might help you meet lenders’ requirements for refinancing and get rid of your PMI.

Bottom line

A common question homeowners have is “how does refinancing work?” Now that you know the basics of mortgage refinancing and the pros and cons of doing so, you can decide whether refinancing your home loan is a good idea for you.

When you’re thinking about refinancing, consider your financial situation, current budget, and the required closing costs. If you’re ready to apply for a loan, check out our picks for the best mortgage lenders of 2021.

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