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The historic low mortgage rates we saw in 2020 are gone, and the 30-year fixed rate mortgage has officially moved above 4%. But if you have an older mortgage with a high interest rate, or you want to length or shorten your repayment term, or you need to take cash out of your home, you may still benefit from knowing how to refinance your mortgage.
But the mortgage refinance process can be complicated, with a lot of moving parts and confusing terms that can lead even experienced homebuyers to throw up their hands in exasperation. So before you start down the road to refinancing, let’s go through the basics on how to refinance your mortgage and look at a few time-saving tips.
What is refinancing?
Refinancing is the process of paying off your existing mortgage with the funds from a new mortgage. While most people refinance to take advantage of a lower interest rate on a new loan, other reasons to refinance include switching mortgage companies, changing the terms of your loan or ending a private mortgage insurance requirement (also known as PMI, more on this below). Refinancing is also a good way to acquire cash to use for home improvements, buy another house or pay off credit card debt.
The process of refinancing is very similar to applying for a mortgage. You’ll need to contact a bank, credit union or mortgage broker and discuss your options, which include a new loan’s terms and costs. Some online services like LendingTree can help automate this process for you by reaching out to multiple lenders at the same time so you can see your options all at once.
What do all these refinance terms mean?
When it comes to refinancing, there are a number of words and terms that you should become familiar with when learning how to refinance your mortgage. Many of them are key variables that you’ll want to take into consideration to determine whether refinancing makes sense for you.
Here’s a glossary of the most important refinancing terms:
Interest rate: This is the amount of money that your bank or credit union charges each year for lending you money in a mortgage. It’s expressed as a percentage (i.e: 3%, 4.25%, 5.76%). The lower your interest rate, the less you’re paying in interest. When you begin the process of refinancing your mortgage, you can typically get a mortgage rate lock, which guarantees that you’ll be able to get the current interest rate on your new mortgage while you proceed through the refinance process.
In some cases, you may be able to pay extra for a float down rate option, which protects you if market interest rates fall while you’re in the middle of refinancing by allowing you to release your rate lock and re-lock at a lower rate.
Annual percentage rate (APR): This is the actual cost of a loan to a borrower. It differs slightly from the interest rate as it includes not just interest, but also additional costs charged by the lender. Again, it’s expressed as a percentage, and lower is better.
Points: These are optional fees paid to the lender to lower your interest rate, which will make your monthly payment smaller. Each point typically costs 1% of your total mortgage amount and reduces your interest rate by 0.25%. So if you’re refinancing a $200,000 mortgage at a new interest rate of 4.25%, you could pay $2,000 for 2 points and reduce your rate to 3.75% on the new mortgage.
Closing: The very last step in a refinance. This is when you will sign all the final legal documents accepting responsibility for the new mortgage, and the funds from your new lender will be transferred to your old lender so your existing mortgage can be paid off.
Closing costs: The fees you’re charged to finalize a mortgage — whether it’s for a new home or a refinance — which you must pay at closing. Common closing costs include an origination fee, which is essentially the fee lenders charge for processing and underwriting a mortgage, and a mortgage finance appraisal fee, which is what it costs the lender to hire an appraiser to determine how much your home is worth.
Sometimes a lender might offer a “no closing costs” refinance option, but you’ll likely pay a higher interest rate for it. Your lender is required to disclose its closing costs at least three business days ahead of closing in a closing disclosure.
Equity: The difference between your home’s current market value and the amount you owe the lender. This is how much of your home you actually own. For instance, if your home is currently worth $300,000 but you have $175,000 left to pay on your mortgage, your equity in your home is $125,000.
Cash out refinance: Refinancing for an amount higher than what you owe on your current mortgage and keeping the extra money. This reduces your equity, but allows you to get cash that can be spent on other necessities, such as home improvements, credit card debt and so on. The opposite of a cash out refinance is a rate-and-term refinance, which is when you refinance to change either the interest rate or the term of your mortgage without taking out any cash.
Fixed-rate mortgage: A type of mortgage in which the interest rate does not change for the entire length of the loan. A 15 or 30-year mortgage will almost always be at a fixed-rate.
Adjustable-rate mortgage (ARM): A type of mortgage in which the interest rate is initially set for a fixed number of years and then can fluctuate periodically after that set time period expires. These mortgages are referred to with a set of numbers such as “3/1 ARM” or “10/1 ARM.” The first number is the length in years during which the rate is fixed. The second number is how often the interest rate can be adjusted after that fixed time period is over, again stated in years.
So a 5/1 ARM will have a fixed rate for the first five years of the mortgage, and then the interest rate can be adjusted once every year after that. Adjustments are usually tied to a public benchmark interest rate such as the prime rate, so they can go up or down depending on financial conditions.
Prepayment penalty: Also sometimes referred to as a repayment penalty, this is an extra fee included in some mortgages that you’ll be charged if you pay off your loan early, either before a specified amount of time or before you’ve paid a certain amount of the principal. If you have a prepayment penalty in your current mortgage, you’ll want to keep that extra cost in mind when considering whether a refinance makes sense for you.
Private mortgage insurance (PMI): When you first buy a house, if you pay less than 20% of the purchase price from your own existing funds, your lender will typically require you to pay for additional ongoing insurance on the mortgage, or PMI. This is because the mortgage must cover more than 80% of the price, making it a riskier investment to the lender. PMI is added to your monthly payment and is non-refundable.
Note that private mortgage insurance is different from Federal Housing Administration (FHA) insurance, which is a similar type of insurance charged on mortgages backed by the FHA, an agency of the Federal government. Unlike PMI, the FHA requires both an upfront insurance payment and an annual insurance payment for all borrowers, not just those with less than 20% in equity. However, FHA loans are typically easier to qualify for and are popular with first-time home buyers.
How to use a refinance calculator
There are many free refinance calculators readily available online which can help you determine if refinancing will save you money. With a refinance calculator, you can enter your current mortgage terms, the new proposed mortgage terms and any fees for refinancing. You can try this refinance calculator to see how it works.
A refinance calculator will help you figure out how much money you’ll save on a monthly basis and over the life of your loan, and whether it’s worth the costs of acquiring a new mortgage.
What are the benefits of refinancing?
There are many benefits to refinancing, but they will vary based on your current situation and financial goals. Typically, the number one benefit is saving money, but there are many others as well.
For instance, with a refinance you can potentially get a better interest rate, lower your monthly payments, shorten the length of your loan, build equity faster, consolidate other existing debts by combining them all into a new mortgage, get rid of your mortgage insurance (if you’re refinancing for less than 80% of the value of your home) or even remove a person from the mortgage.
What are the risks of refinancing?
Although there are many benefits to refinancing, it isn’t right for everyone. As with any financial transaction, you’ll want to make sure the math works in your favor.
Normally, you’ll be charged closing costs to refinance. These costs can often be folded into your new mortgage, but doing so will add to your monthly payments. Therefore, you’ll want to fully understand these charges and take them into account to ensure that your monthly savings from a refinance will more than offset the costs.
To calculate how long it will take before the monthly savings from your new mortgage outweighs its closing costs (the “break-even” point), use a refinance calculator and enter the basic information about your current mortgage and the new mortgage.
If you find that the break-even point on your new mortgage is 7 years, but you only plan on staying in your house for another 5 years, then refinancing might actually be more costly than just keeping your current mortgage, even if its interest rate is higher.
You’ll also want to keep the length of your new mortgage in mind. All mortgages are designed so that you’re paying more interest than principal in the first half of the mortgage. That means if you’re starting a new mortgage with a refinance, you’ll be paying the bulk of the interest again at the top after previously paying the bulk of the interest in the first years of your old mortgage.
For example, if you currently have a 30-year mortgage and you’re halfway through it, but then you refinance into another 30-year mortgage, you’ll ultimately be paying interest on your mortgage for a total of 45 years. Even if your monthly payments are less with a refinance, your overall interest paid would likely be significantly higher.
If you’re already more than 10 years into a 30-year mortgage, you’ll want to opt for a shorter length when you refinance. A 15 or 20-year mortgage will prevent you from having to pay a lot in extra interest.
How does your credit score affect refinance rates?
When looking to refinance, you’ll want to make sure to have a healthy credit score. The lower your credit score, the higher your interest rate and the more you’ll pay in interest.
For example, a credit score below 700 versus one above 700 could potentially cost you a half percent. On a $190,000 30-year mortgage, that could mean paying roughly another $55 per month. Over a 30-year timespan, the difference is quite costly — approximately another $20,000.
So if you know you’re going to refinance your home in the near future, make sure all your payments on your existing credit obligations are up to date, and be cautious of making any moves that will negatively impact your credit score in the short term, such as taking on a new car loan or applying for new credit cards.
Should you refinance your mortgage?
Understanding the basics will help you make the best decision on whether a refinance makes sense for you, and then move quickly if you decide to refinance. You’ll want to not only look at the current interest rates and closing costs, but also think about your personal situation and your financial goals.
For instance, if you’re planning to move in a few years, it’s likely that a refinance won’t make sense, since you won’t have enough time with the better terms of the new mortgage to offset the closing costs. But if you’re staying put in your house for the long haul and can get an interest rate that’s significantly lower than your current mortgage (at least 1% less), then there’s a good chance refinancing will ultimately save you money.
If after using a refinance calculator you find that a refinance makes sense for you, make sure you compare lenders and brokers to find the best mortgage refinance rates, as well as the lowest closing costs. Use an online comparison tool to quickly compare refinance terms across multiple lenders.
Once you decide that refinancing is the best move for you, knowing how to refinance your mortgage can make the process seem more straightforward, and you’ll be on your way to saving money and hitting your personal financial goals.