What Does It Mean to Refinance a Mortgage?

Refinancing a mortgage means taking out a new home loan that pays off your current one, so you keep the same house but get a new interest rate, loan term, and monthly payment. Most people refinance to lower their rate or payment, shorten the term, switch from an adjustable rate to a fixed rate, or take cash out of their home equity. You apply and qualify much as you did for your first mortgage, and you pay closing costs that Freddie Mac puts at 3% to 6% of the loan amount.

How does a refinance pay off your old loan?

A refinance is a new loan, not a change to your existing one. The steps run like this:

1. You apply with a lender, which can be your current servicer (the company you send payments to) or a different lender.
2. The lender checks your credit, income, and debts, and usually orders an appraisal to set the home's value.
3. At closing you sign the new loan documents. The settlement agent uses the new loan money to pay your old lender the payoff amount, which is your remaining principal plus interest owed up to the payoff date.
4. The new loan becomes the mortgage on your home.

On a refinance of your primary home, federal Truth in Lending rules give you until midnight of the third business day after the latest of signing the loan contract, receiving the required disclosures, or receiving the cancellation notice to cancel. Saturdays count; Sundays and legal public holidays do not. The lender cannot release the loan money until that period ends. If you refinance with the same lender that holds your current loan, the right to cancel covers only new money borrowed beyond your existing balance and the refinance costs.

The new loan has its own repayment term. That changes what you pay in total, not just per month. Example: you owe $250,000 at 7% with 25 years left, so your principal and interest payment is $1,766.95.

The 30-year refinance cuts the payment the most but adds five years of payments and about $9,500 in total cost before closing costs. Matching the new term to the years you have left keeps the savings from coming out of a longer loan.

What are the main types of refinance?

Fannie Mae calls a rate-and-term refinance a "limited cash-out" refinance, and Freddie Mac calls it a "no cash-out" refinance. Loan-to-value ratio (LTV) is your loan amount divided by the home's appraised value.

Each type has its own rules for how long you must have owned the home or paid the current loan:

• Conventional cash-out: the loan being paid off must be at least 12 months old, and at least one borrower must have been on the title for 6 months.
• FHA cash-out: you must have owned and lived in the home as your primary residence for the 12 months before applying and made every payment within the month due for the past 12 months.
• FHA streamlined refinance: when FHA assigns the case number for your refinance, at least 210 days must have passed since your current loan closed, you must have made at least six payments, and at least six full months must have passed since the first payment due date. The new loan must give you a net tangible benefit, such as a lower combined rate (interest rate plus mortgage insurance premium) or a move from an adjustable to a fixed rate.
• VA streamlined refinance: the later of 210 days after your current loan's first payment due date or the date you have made six consecutive monthly payments on that loan.
• USDA streamlined options: your mortgage payment history must show no payment more than 30 days late during the 180 days before submission to USDA. The new rate must be fixed and no higher than your current rate, and no cash out is allowed. For streamlined-assist, the lender must also verify that your combined monthly payment for principal, interest, and the annual fee drops by at least $50.

Why do people refinance?

Most refinances aim at one of these goals:

• Lower rate or payment. This is worth it when your monthly savings repay your closing costs before you sell or refinance again. In the 25-year example above, $6,000 in closing costs divided by $156.19 a month in savings takes about 39 months to recover. When to refinance covers that break-even test in detail.
• Shorter term. Moving from a 30-year to a 15-year loan raises the monthly payment but cuts total interest.
• Adjustable to fixed. A fixed rate ends the risk of payment increases when an adjustable rate resets.
• Drop mortgage insurance. Fannie Mae requires mortgage insurance on a conventional loan above 80% LTV, so refinancing at 80% or less after your home has gained value removes it. Paying off an FHA loan with a conventional loan at 80% LTV or less also ends FHA's annual premium.
• Take cash out. A cash-out refinance turns equity into cash for repairs, debt payoff, or other costs, at the price of a larger loan.

What does refinancing cost and require?

Costs. Freddie Mac estimates refinance costs at 3% to 6% of the loan principal. They include the origination fee and charges for the appraisal, credit report, title, recording, underwriting, and in some states an attorney, plus any discount points you buy to lower the rate. A lender may add the costs to your loan balance or offer a "no-cost" refinance, which Freddie Mac notes usually comes with a higher rate. The costs and fees of refinancing lists each charge.

Requirements. The lender looks at four things:

1. Your credit score, which affects both approval and the price of the loan.
2. Your debt-to-income ratio (DTI), your monthly debt payments divided by your gross monthly income, including the new mortgage payment.
3. Your equity, measured as LTV against the program limits in the table above.
4. Your payment history on the current loan and how long you have had it.

What lenders require to approve a refinance gives the numbers for each loan type, and how to refinance walks through the application, rate lock, and closing.

Is a cash-out refinance better than a HELOC or home equity loan?

All three let you borrow against your equity, and the home secures each one, so falling behind on payments can lead to foreclosure. The difference is whether you replace your first mortgage or add a second loan behind it.

The deciding number is usually your current rate. A cash-out refinance reprices your entire balance, while a home equity loan or HELOC leaves your first mortgage untouched. Example with hypothetical rates: you owe $300,000 at 3.5% with 25 years left and need $50,000.

• Keep the first mortgage and add a 15-year home equity loan at 8%: $1,501.87 plus $477.83, or $1,979.70 a month, and about $14,300 in interest in the first year.
• Cash-out refinance to $350,000 at 6.25% for 30 years: $2,155.01 a month and about $21,800 in interest in the first year, before closing costs on the full $350,000.

If your current rate is at or above today's refinance rates, a cash-out refinance may cost less than adding a second loan and gives you one payment instead of two. A HELOC fits a cost that comes in stages, such as a renovation, because you pay interest only on what you draw. What a HELOC is explains how the draw and repayment periods work, and HELOC or home equity loan compares the two ways to borrow against your home.