It’s time to rethink your mortgage.

A lot of people think that once you have a mortgage, you’re locked into it until you pay it off. While it’s true that you can’t just get rid of your home loan, you can refinance it into a new one.

Refinancing helps many people to lower their interest rates, reduce their monthly payments, shorten the terms of their loans, and even get cash from their equity. Whether your finances have improved or the market has, a home loan refinance can set you up for savings.

What Is a Home Loan Refinance?

[Pull quote: Refinancing your mortgage means taking out a new loan to pay off and replace your current one.]

Refinancing your mortgage means taking out a new loan to pay off and replace your current one. It works a lot like getting a first mortgage, except that you have more options.

How It Works

To refinance your mortgage, you need to apply with a lending company. The company looks at your financial information, including your income and existing debts, and decides what interest rate and term you qualify for.

After you sign an agreement to accept the new loan, the lending company will pay off your existing mortgage. If you’ve decided to use the refinancing to borrow against your equity (more on that in a moment), you’ll also get a cash payout that the company will add to your mortgage balance. You’ll then start paying off the refinanced loan as your new mortgage.

Common Types of Refinancing

There are three basic types of home refinance. To pick one, you need to decide whether you want to borrow the same, more, or less than you owe on your current mortgage.

Rate-and-Term Refinance

A rate-and-term refinance gives you a new mortgage that has the same balance as the one you currently hold. What’s different is the interest rate, loan term, or both. Because the new loan has the same balance as the initial mortgage, it’s sometimes called a no cash-out refinance.

Most of the time, people choose rate-and-term refinance when they can get a lower interest rate than they had on their original mortgage. That’s why applications for this kind of refinance often increase when interest rates drop, as they did in late 2019 and early 2020.

Cash-Out Refinance

A cash-out refinance lets you turn some of your home equity into cash. Equity is the portion of your property’s value that isn’t currently mortgaged. For example, if you owe $100,000 on a $250,000 home, your equity is $150,000.

When you refinance your mortgage, you can choose to convert some of that equity into cash. The loan company will add the amount of cash you collect to the balance of your mortgage. You’ll owe more than you do now but, depending on the term and interest rate of the new loan, you could still pay less per month.

Cash-In Refinance

The cash-in refinance is less common than cash-out or rate-and-term refinancing. Instead of borrowing against your equity, you pay an additional sum to reduce your total amount owed. It’s like making a second down payment.

You might choose a cash-in refinance if you’re underwater on your mortgage, meaning that you owe more on your house than it’s worth. Contributing cash to your refinance can bring you back under the limit faster, especially if you can secure a lower interest rate and start paying down your balance faster.

A cash-in refinance might also be the way to go if you currently have private mortgage insurance (PMI). PMI is usually a requirement for borrowers who put less than 20% down on a conventional (non-government-backed) mortgage. If you can bring your mortgage balance under 80% of your home’s value with cash-in, you could save hundreds every month.

The Pros and Cons of Refinancing

[pull quote: If your finances have improved since you bought your home, you might be able to refinance and qualify for lower interest rates.]

As with any financial decision, refinancing has its benefits and drawbacks. Before you apply, consider your financial situation and whether a home loan refinance makes sense for you at the moment.

The Pros

You can switch to a fixed interest rate. Variable interest rates change according to market trends, increasing when interest rates rise overall and decreasing when rates drop. Fixed rates stay the same no matter what the market does. By refinancing from a variable to a fixed interest rate, especially when interest rates are particularly low, you can protect yourself against future interest spikes.

You can benefit from a stronger borrowing profile. If your finances have improved since you bought your home, you might be able to refinance and qualify for lower interest rates.  

You could pay off your mortgage faster. Some people refinance into shorter loan terms. You’ll end up with higher monthly payments this way unless you do a cash-in refinance or qualify for a significantly lower interest rate. On the other hand, you’ll make your last payment sooner, and that means you’ll accrue less interest when all is said and done.

You could save money overall. According to the National Bureau of Economic Research, homeowners stand to save thousands by refinancing when interest rates drop. In one study of households that could have refinanced but didn’t, the largest group missed out on savings of nearly $9,000. Some households lost out on savings of $30,000, $40,000, or more.

https://www.nber.org/digest/jan15/w20401.html

That’s not a regret you want to have.

You can use your equity to finance home improvements. A cash-out refinance could give you the money you need to make additions or improvements to your home. This strategy makes the most financial sense when you choose improvements that boost your home's value.

The Cons

There will be costs involved. A home refinance is a new loan, and that means you’ll have to pay closing costs. For most people, closing costs work out to between 2% and 5% of the total loan balance. On a $150,000 loan, you’ll end up paying between $3,000 and $7,500.

You could have a mortgage for longer. If you refinance into a 30-year mortgage, you’ll have a mortgage for 30 more years. That might be much longer than you have left on your current mortgage.

You could end up paying more. Even with a lower interest rate, if you add years to your mortgage-paying life, your interest may build up to the point that you’re not saving money overall.

You may have the option of refinancing to a shorter term, usually 15 years instead of 30, in which case you’re more likely to save money overall. On the other hand, with a shorter term, your monthly interest payments are usually higher.

Cashing Out: When to Do It and When to Pass

If you’re deciding between a cash-out and a rate-and-term refinance, consider what you’re using the money for.

As mentioned, using the cash to improve your home can be a smart financial move. Not only can it increase your selling price in the future, but you can deduct the interest you pay on that cash-out when you file your taxes. According to the IRS, home loan interest is deductible if you use it to “buy, build, or substantially improve” your property.

You can also come out ahead if you use your cash to consolidate your high-interest debt. You won’t be able to deduct the interest on that cash when you file your taxes, but it can be worth it if you’ll save enough on interest charges.

Still not sure? Ask yourself:

• Will the cash-out improve my financial picture in the end?
• Is it an emergency?

If the answer to either question is yes, you can feel okay about considering a cash-out refinance.

How to Refinance Your Mortgage

[Pull quote: If your financial situation has improved—maybe your income has gone up, you’ve paid off some debts, or your credit score has gone up—you’re more likely to qualify for better terms.]

Ready to get started refinancing your mortgage? The early stages of the process are low commitment, so let's get started.

Step 1: Choose Your Loan Type

You can shop around for multiple loan types at once, especially if you’re not sold on one type over another, but it does help to know what your first-choice refinance strategy is. Do you want:

• A rate-and-term, cash-out, or cash-in refinance?
• An adjustable-rate or fixed-rate loan?
• A 15-year, 30-year, or custom option?
  
  

Step 2: Check Your Qualifications

To determine whether you qualify for a home loan refinance and come up with an offer, lending companies will look at your income, expenses, and borrowing history. The stronger your borrowing profile, the lower your interest rate will be.

Credit Score and History

According to the credit bureau Experian, most private lending companies want you to have a score of 620 or higher to refinance. Borrowers with higher scores tend to qualify for lower interest rates.

If you know you’re in the market for a home loan refinance, work on bringing or keeping your credit score down. Make your payments on time and pay off balances, especially on high-interest cards.

Debt-to-Income Ratio

To determine if you can afford the payments on your refinanced mortgage, loan companies will look at your debt-to-income ratio (DTI). Your DTI is the total of your monthly debt payments divided by your monthly income before taxes.

For example, if you have a car payment of $500, a student loan payment of $500, and an existing mortgage payment of $1,000, your monthly debts add up to $2,000. If your monthly gross income is $5,000, then your DTI is 40%.

According to the Consumer Financial Protection Bureau, loan companies prefer a borrower’s DTI to be no higher than 43%. Again, the lower your DTI, the better.

Your Existing Mortgage and Equity

Loan companies will also look at your current home when considering you for a mortgage. Specifically, they’ll look at:

• Your payment history
• The home’s current value
• Your mortgage debt vs. the equity you’ve built up

When you divide your mortgage debt by the total value of your home, you get your loan-to-value ratio (LTV). You can refinance if your LTV is as high as 95%, depending on the company you’re working with.

Now vs. Then

As you look at your financial standing and creditworthiness as a refinance borrower, pay particular attention to how you’re doing now versus when you first took out your current mortgage. If your financial situation has improved—maybe your income has gone up, you’ve paid off some debts, or your credit score has gone up—you’re more likely to qualify for better terms.

Step 3: Shop Around and Get Quotes

According to Freddie Mac, a government-sponsored organization dedicated to mortgage affordability, getting a second rate quote can save you $1,500 over the life of the loan. Getting five quotes can save you $5,000.

Look at Averages

You can check loan companies’ average interest rates without any commitment at all. Lower.com publishes a daily average mortgage rate, along with the national average rate of several key competitors. These rates are for initial mortgages, but the differences between the rates can tell you a lot about what you can expect as a refinancing applicant.

Get an Estimate

By looking around at average interest rates, you can come up with a shortlist of possible loan companies you’re interested in working with. Take that list and find out which companies will give you personalized quotes.

Before you submit your information, make sure the company won’t do a hard credit check for this preliminary step. A hard credit check is typically necessary when you submit a formal application with the company you ultimately choose to work with, but too many of these can hurt your credit score.

To keep your score safe, limit your pre-application to companies like Lower.com that will only do a soft credit check.

Ask Questions

There are several reasons why you’d want to talk to a loan company before you submit a formal application. One is to clarify any numbers that you see on your quote. Is your interest rate set in stone, for example, or is there anything you can do to bring it down?

Another question to ask is whether you can match your current loan term. This is a helpful solution for borrowers who don’t want to shorten their loan term from 30 to 15 years, but who also don’t want to take on another 30 years of mortgage payments. If you have 20 years left on your mortgage and get approved to have your term matched, your refinanced loan could still have just 20 years on it.

Another reason to ask questions is to find out how your loan company works with customers. You’ll be working with the company you choose for years, so you want to feel good about talking to its representatives.

Make sure the company communicates the way you do. If you’re one of the many people who like to contact companies via text, for example, you’ll want a company like Lower that’s happy to text with you.

Step 4: Submit an Application

Once you’ve chosen a loan company to work with, you can submit a formal application. It’s okay to submit more than one of these if you’re still considering more than one company, but if you do, complete all of your applications in as little time as possible.

Credit bureaus tend to assume that when you apply multiple times for the same type of credit in a short time frame, you’re shopping around. As long as you submit your applications within a period of a few weeks, they will usually only count as a single pull on your credit history.

When you apply, you’ll have to submit financial documentation that proves your income and expenses. Commonly requested documents include:

• Photo ID
• Tax Returns
• Proof of Income
• Asset Statements
• Written Support
• Residential History
• List of Other Debts
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Be aware that if you’re self-employed, you’ll probably need to submit additional documentation to take the place of paperwork like pay stubs and W-2 tax forms. Many companies ask self-employed borrowers for additional years of tax returns or profit-and-loss statements.
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Step 5: Review Your Offer and Sign

Once a loan company has reviewed your application and determined that you qualify for a loan, you’ll get a letter of approval and disclosures. Those disclosures will give you the details you need about the total amount, interest rate, closing costs, and so on.

This is another time when you should ask as many questions as you can until you’re sure you understand the process. When you feel comfortable, you can sign the agreement, collect your cash if you’re doing cash-out, and start paying your new mortgage.

Refinancing Mistakes to Avoid

[Pull quote: It’s tempting to sign with the first company to offer you a refinancing rate that’s lower than your current rate, but you might pay for that haste in the long run.]

Refinancing can save you a lot of money in the long run. It’s still a big financial decision though, and it’s important to go about it the right way. By avoiding these common mistakes, you’ll have a better chance of a successful refinance experience.

Falling for Scams

Loan scammers know that a lot of people are considering a home loan refinance while interest rates are low. They have no reservations about taking advantage of your desire to save money.

As you shop around for options, keep an eye out for the following red flags:

• Requests for your personally identifiable information, such as your bank account or social security number
• Suspiciously low interest rates
• Unsolicited “personal” offers

Most importantly, don’t ever send fees upfront. It’s illegal for any loan company to request payment before you have accepted an official offer.

Cashing Out Too Much Equity

Once you know you can borrow against your equity as part of your home loan refinance, it’s tempting to use the process as a personal ATM or low-interest credit card. But keep in mind that you have to repay all of the cash you take out plus interest.

Also, the more you take out, the higher your new mortgage balance will be. If it creeps too close to the value of your home, you risk going underwater if home prices drop. That doesn’t mean you shouldn’t cash out equity if it makes sense to do so, but be careful not to overdo it.

Not Calculating Your Break-Even Point

It’s easy to get so excited about the prospect of saving money that you rush into refinancing. Before you do that, do some math to make sure that the costs of the home loan refinance will outweigh the benefits.

Remember, all refinances come with closing costs. Some lending companies will fold those costs into the loan so you don’t pay them all at once. Others will offer to waive some fees in exchange for a higher interest rate. Either way, there are expenses involved.

Before you sign a refinancing agreement, calculate how long it will take to recoup the costs. The refinance breakeven calculator from the American Institute of CPAs can help. You’ll enter key information like the balance of your mortgage, the interest rate and term of your new loan, and closing costs, and it will tell you how long it will take for the costs of refinancing to pay for itself.

Neglecting to Shop for the Best Rate

It’s tempting to sign with the first company to offer you a refinancing rate that’s lower than your current rate, but you might pay for that haste in the long run.

Let’s say you’re refinancing $160,000 on a $200,000 home. The first company you talk to offers you 4% interest, but you shop around and finally find a company that will offer you 3%. That one percent will save you about $100 a month. If you sign on for a full 30-year term, you’ll pay about $30,000 less in interest.

Key Takeaways

Refinancing your mortgage can save you thousands or even tens of thousands of dollars. It can also give you the opportunity to cash out some of the equity you’ve been building up in your home.

Before you refinance, make sure your credit score is strong and your debt-to-income ratio is as low as possible. Then, do some comparison shopping and find out where you can get the best rates.

As you shop around, remember to ask about what makes each lender unique. Lower.com offers free refinancing for life on all loans originated in-house. The more you know about your options, the better prepared you'll be to make the right decision.