Deciding to refinance your mortgage is only the beginning of the process. You’re far more likely to accomplish what you set out to achieve with your refinance — and to get a good deal in the meantime — when you understand what a mortgage refinance entails.
From decision to closing, mortgage refinancing applicants pass through four key stages on their journey to a new mortgage loan.
How to Refinance a Mortgage on Your Home
Getting a home loan of any kind is a highly involved and consequential process.
On the front end, it requires careful consideration on your part. In this case, that means weighing the pros and cons of refinancing in general and the purpose of your loan in particular.
For example, are you refinancing to get a lower rate loan (reducing borrowing costs relative to your current loan) or do you need a cash-out refinance to finance a home improvement project, which could actually entail a higher rate?
Next, you’ll need to gather all the documents and details you’ll need to apply for your loan, evaluate your loan options and calculate what your new home mortgage will cost, and then begin the process of actually shopping for and applying for your new loan — the longest step in the process.
Expect the whole endeavor to take several weeks.
1. Determining Your Loan’s Purpose & Objectives
The decision to refinance a mortgage is not one to make lightly. If you’ve decided to go through with it, you probably have a goal in mind already.
Still, before getting any deeper into the process, it’s worth reviewing your longer-term objectives and determining what you hope to get out of your refinance. You might uncover a secondary or tertiary goal or benefit that alters your approach to the process before it’s too late to change course.
Refinancing advances a whole host of goals, some of which are complementary. For example:
- Accelerating Payoff. A shorter loan term means fewer monthly payments and quicker payoff. It also means lower borrowing costs over the life of the loan. The principal downside: Shortening a loan’s remaining term from, say, 25 years to 15 years is likely to raise the monthly payment, even as it cuts down total interest charges.
- Lowering the Monthly Payment. A lower monthly payment means a more affordable loan from month to month — a key benefit for borrowers struggling to live within their means. If you plan to stay in your home for at least three to five years, accepting a prepayment penalty (which is usually a bad idea) can further reduce your interest rate and your monthly payment along with it. The most significant downsides here are the possibility of higher overall borrowing costs and taking longer to pay it off if, as is often the case, you reduce your monthly payment by lengthening your loan term.
- Lowering the Interest Rate. Even with an identical term, a lower interest rate reduces total borrowing costs and lowers the monthly payment. That’s why refinancing activity spikes when interest rates are low. Choose a shorter term and you’ll see a more drastic reduction.
- Avoiding the Downsides of Adjustable Rates. Life is good for borrowers during the first five to seven years of the typical adjustable-rate mortgage (ARM) term when the 30-year loan rate is likely to be lower than prevailing rates on 30-year fixed-rate mortgages. The bill comes due, literally, when the time comes for the rate to adjust. If rates have risen since the loan’s origination, which is common, the monthly payment spikes. Borrowers can avoid this unwelcome development by refinancing to a fixed-rate mortgage ahead of the jump.
- Getting Rid of FHA Mortgage Insurance. With relaxed approval standards and low down payment requirements, Federal Housing Administration (FHA) mortgage loans help lower-income, lower-asset first-time buyers afford starter homes. But they have some significant drawbacks, including pricey mortgage insurance that lasts for the life of the loan. Borrowers with sufficient equity (typically 20% or more) can put that behind them, reduce their monthly payment in the process by refinancing to a conventional mortgage, and avoid less expensive but still unwelcome private mortgage insurance (PMI).
- Tapping Home Equity. Use a cash-out refinance loan to extract equity from your home. This type of loan allows you to borrow cash against the value of your home to fund things like home improvement projects or debt consolidation. Depending on the lender and jurisdiction, you can borrow up to 85% of your home equity (between rolled-over principal and cash proceeds) with this type of loan. But mind your other equity-tapping options: a home equity loan or home equity line of credit.
Confirming what you hope to get out of your refinance is an essential prerequisite to calculating its likely cost and choosing the optimal offer.
2. Confirm the Timing & Gather Everything You Need
With your loan’s purpose and your long-term financial objectives set, it’s time to confirm you’re ready to refinance. If yes, you must gather everything you need to apply, or at least begin thinking about how to do that.
Assessing Your Timing & Determining Whether to Wait
The purpose of your loan plays a substantial role in dictating the timing of your refinance.
For example, if your primary goal is to tap the equity in your home to finance a major home improvement project, such as a kitchen remodel or basement finish, wait until your loan-to-value ratio is low enough to produce the requisite windfall. That time might not arrive until you’ve been in your home for a decade or longer, depending on the property’s value (and change in value over time).
As a simplified example, if you accumulate an average of $5,000 in equity per year during your first decade of homeownership by making regular payments on your mortgage, you must pay your 30-year mortgage on time for 10 consecutive years to build the $50,000 needed for a major kitchen remodel (without accounting for a potential increase in equity due to a rise in market value).
By contrast, if your primary goal is to avoid a spike in your ARM payment, it’s in your interest to refinance before that happens — most often five or seven years into your original mortgage term.
But other factors can also influence the timing of your refinance or give you second thoughts about going through with it at all:
- Your Credit Score. Because mortgage refinance loans are secured by the value of the properties they cover, their interest rates tend to be lower than riskier forms of unsecured debt, such as personal loans and credit cards. But borrower credit still plays a vital role in setting their rates. Borrowers with credit scores above 760 get the best rates, and borrowers with scores much below 680 can expect significantly higher rates. That’s not to say refinancing never makes sense for someone whose FICO score is in the mid-600s or below, only that those with the luxury to wait out the credit rebuilding or credit improvement process might want to consider it. If you’re unsure of your credit score, you can check it for free through Credit Karma.
- Debt-to-Income Ratio. Mortgage lenders prefer borrowers with low debt-to-income ratios. Under 36% is ideal, and over 43% is likely a deal breaker for most lenders. If your debt-to-income ratio is uncomfortably high, consider putting off your refinance for six months to a year and using the time to pay down debt.
- Work History. Fairly or not, lenders tend to be leery of borrowers who’ve recently changed jobs. If you’ve been with your current employer for two years or less, you must demonstrate that your income has been steady for longer and still might fail to qualify for the rate you expected. However, if you expect interest rates to rise in the near term, waiting out your new job could cancel out any benefits due to the higher future prevailing rates.
- Prevailing Interest Rates. Given the considerable sums of money involved, even an incremental change to your refinance loan’s interest rate could translate to thousands or tens of thousands of dollars saved over the life of the loan. If you expect interest rates to fall in the near term, put off your refinance application. Conversely, if you believe rates will rise, don’t delay. And if the difference between your original mortgage rate and the rate you expect to receive on your refinance loan isn’t at least 1.5 percentage points, think twice about going ahead with the refinance at all. Under those circumstances, it takes longer to recoup your refinance loan’s closing costs.
- Anticipated Time in the Home. It rarely makes sense to refinance your original mortgage if you plan to sell the home or pay off the mortgage within two years. Depending on your expected interest savings on the refinance, it can take much longer than that (upward of five years) to break even. Think carefully about how much effort you want to devote to refinancing a loan you’re going to pay off in a few years anyway.
Pro tip: If you need to give your credit score a bump, sign up for Experian Boost. It’s free and it’ll help you instantly increase your credit score.
Gathering Information & Application Materials
If and when you’re ready to go through with your refinance, you need a great deal of information and documentation before and during the application and closing processes, including:
- Proof of Income. Depending on your employment status and sources of income, the lender will ask you to supply recent pay stubs, tax returns, or bank statements.
- A Recent Home Appraisal. Your refinance lender will order a home appraisal before closing, so you don’t need to arrange one on your own. However, to avoid surprises, you can use open-source comparable local sales data to get an idea of your home’s likely market value.
- Property Insurance Information. Your lender (and later, mortgage servicer) needs your homeowners insurance information to bundle your escrow payment. If it has been more than a year since you reviewed your property insurance policy, now’s the time to shop around for a better deal.
Be prepared to provide additional documentation if requested by your lender before closing. Any missing information or delays in producing documents can jeopardize the close.
3. Calculate Your Approximate Refinancing Costs
Next, use a free mortgage refinance calculator like Bank of America’s to calculate your approximate refinancing costs.
Above all else, this calculation must confirm you can afford the monthly mortgage payment on your refinance loan. If one of your aims in refinancing is to reduce the amount of interest paid over the life of your loan, this calculation can also confirm your chosen loan term and structure will achieve that.
For it to be worth it, you must at least break even on the loan after accounting for closing costs.
Calculating Your Breakeven Cost
Breakeven is a simple concept. When the total amount of interest you must pay over the life of your refinance loan matches the loan’s closing costs, you break even on the loan.
The point in time at which you reach parity is the breakeven point. Any interest saved after the breakeven point is effectively a bonus — money you would have forfeited had you chosen not to refinance.
Two factors determine if and when the breakeven point arrives. First, a longer loan term increases the likelihood you’ll break even at some point. More important still is the magnitude of change in your loan’s interest rate. The further your refinance rate falls from your original loan’s rate, the more you save each month and the faster you can recoup your closing costs.
A good mortgage refinance calculator should automatically calculate your breakeven point. Otherwise, calculate your breakeven point by dividing your refinance loan’s closing costs by the monthly savings relative to the original loan and round the result up to the next whole number.
Because you won’t have exact figures for your loan’s closing costs or monthly savings until you’ve applied and received loan disclosures, you’re calculating an estimated breakeven range at this point.
Refinance loan closing costs typically range from 2% to 6% of the refinanced loan’s principal, depending on the origination fee and other big-ticket expenses, so run one optimistic scenario (closing costs at 2% and a short time to breakeven) and one pessimistic scenario (closing costs at 6% and a long time to breakeven). The actual outcome will likely fall somewhere in the middle.
Note that the breakeven point is why it rarely makes sense to bother refinancing if you plan to sell or pay off the loan within two years or can’t reduce your interest rate by more than 1.5 to 2 percentage points.
4. Shop, Apply, & Close
You’re now in the home stretch — ready to shop, apply, and close the deal on your refinance loan.
Follow each of these steps in order, beginning with a multipronged effort to source accurate refinance quotes, continuing through an application and evaluation marathon, and finishing up with a closing that should seem breezier than your first.
Use a Quote Finder (Online Broker) to Get Multiple Quotes Quickly
Start by using an online broker like Credible* to source multiple refinance quotes from banks and mortgage lenders without contacting each party directly. Be prepared to provide basic information about your property and objectives, such as:
- Property type, such as single-family home or townhouse
- Property purpose, such as primary home or vacation home
- Loan purpose, such as lowering the monthly payment
- Property zip code
- Estimated property value and remaining first mortgage loan balance
- Cash-out needs, if any
- Basic personal information, such as estimated credit score and date of birth
If your credit is decent or better, expect to receive multiple conditional refinance offers — with some coming immediately and others trickling in by email or phone in the subsequent hours and days. You’re under no obligation to act on any, sales pressure notwithstanding, but do make note of the most appealing.
Approach Banks & Lenders You’ve Worked With Before
Next, investigate whether any financial institutions with which you have a preexisting relationship offer refinance loans, including your current mortgage lender.
Most banks and credit unions do offer refinance loans. Though their rates tend to be less competitive at a baseline than direct lenders without expensive branch offices, many offer special pricing for longtime or high-asset customers. It’s certainly worth taking the time to make a few calls or website visits.
Apply for Multiple Loans Within 14 Days
You won’t know the exact cost of any refinance offer until you officially apply and receive the formal loan disclosure all lenders must provide to every prospective borrower.
But you can’t formally apply for a refinance loan without consenting to a hard credit pull, which can temporarily depress your credit score. And you definitely shouldn’t go through with your refinance until you’ve entertained multiple offers to ensure you’re getting the best deal.
Fortunately, the major consumer credit-reporting bureaus count all applications for a specific loan type (such as mortgage refinance loans) made within a two-week period as a single application, regardless of the final application count.
In other words, get in all the refinance applications you plan to make within two weeks, and your credit report will show just a single inquiry.
Evaluate Each Offer
Evaluate the loan disclosure for each accepted application with your objectives and general financial goals in mind. If your primary goal is reducing your monthly payment, look for the loan with the lowest monthly cost.
If your primary goal is reducing your lifetime homeownership costs, look for the loan offering the most substantial interest savings (the lowest mortgage interest rate).
Regardless of your loan’s purpose, make sure you understand what (if anything) you’re obligated to pay out of pocket for your loan. Many refinance loans simply roll closing costs into the principal, raising the monthly payment and increasing lifetime interest costs.
If your goal is to get the lowest possible monthly payment and you can afford to, try paying the closing costs out of pocket.
Choose an Offer & Consider Locking Your Rate
Choose the best offer from the pack — the one that best suits your objectives. If you expect rates to move up before closing, consider the lender’s offer (if extended) to lock your rate for a predetermined period, usually 45 to 90 days.
There’s likely a fee associated with this option, but the amount saved by even marginally reducing your final interest rate will probably offset it. Assuming everything goes smoothly during closing, you shouldn’t need more than 45 days — and certainly not more than 90 days — to finish the deal.
Proceed to Closing
Once you’ve closed on the loan, that’s it — you’ve refinanced your mortgage. Your refinance lender pays off your first mortgage and originates your new loan.
Moving forward, you send payments to your refinance lender, their servicer, or another company that purchases the loan.
If you own a home, refinancing your mortgage loan is likely the easiest route to capitalize on low interest rates. It’s probably the most profitable too.
But low prevailing interest rates aren’t the only reason to refinance your mortgage loan. Other common refinancing goals include avoiding the first upward adjustment on an ARM, reducing the monthly payment to a level that doesn’t strain your growing family’s budget, tapping the equity you’ve built in your home, and banishing FHA mortgage insurance.
And a refinance loan doesn’t need to achieve only one goal. Some of these objectives are complementary, such as reducing your monthly payment while lowering your interest rate (and lifetime borrowing costs).
Provided you make out on the deal, whether by reducing your total homeownership costs or taking your monthly payment down a peg, it’s likely worth the effort.
*Advertisement from Credible Operations, Inc. NMLS 1681276.Address: 320 Blackwell St. Ste 200, Durham, NC, 27701