How Does Refinancing a Mortgage Work?

Quick Answer

Refinancing a mortgage loan involves replacing your existing loan with a new one, typically through a different lender. In general, the process is very similar to the traditional mortgage process.

An elderly man uses his tablet while sitting on a chair at home.

Refinancing a mortgage involves taking out a new loan to pay off your original mortgage loan. Before you start the process, however, it's important to know how the process works and both the benefits and drawbacks of mortgage refinancing.

How Does Refinancing Work?

Refinancing a home loan involves replacing your existing mortgage with a new one, typically to obtain terms that are more favorable or that fit your financial goals. The process of refinancing a mortgage is similar to the process you went through when you obtained your first mortgage loan. Here are the steps you'll need to take.

1. Assess Your Situation

The qualifications for refinancing a mortgage are similar to the criteria for a new mortgage loan. Lenders will consider several factors, including your:

  • Credit history and score
  • Payment history on your existing loan
  • Income and employment history
  • Equity in the home
  • Home's current value
  • Other debt obligations

As a result, you'll want to review where you stand in each of these areas to determine your eligibility. If, for example, you have a spotless credit history, a solid income and a lot of equity in your home, you may get approved for better terms on a new loan.

If, however, your credit score has gone down since you got your first mortgage or you have more overall debt, you may have a harder time getting approved for more favorable terms.

2. Shop Around

Go through the preapproval process with multiple mortgage lenders so you can compare interest rates and other terms. This will give you the highest chance of finding the best offer that's available for you.

In addition to comparing refinance offers with each other, you'll also want to compare what you're seeing with your current mortgage loan terms. This can help you determine whether refinancing is the right move.

3. Run the Numbers

Once you've chosen the best offer that's available to you, compare the potential savings to the potential costs.

For example, if refinancing your loan with a new lender costs $5,000 upfront, and your new monthly payment is just $100 lower than what you were previously paying, you'd need to stay in the home for at least 50 months to make refinancing worth it. If you're not planning on staying in the home very long, refinancing may not be the right move.

Also, watch out for things like prepayment penalties, which can cause problems down the road if you pay off your existing mortgage early or refinance again.

4. Submit Your Application

When you're ready to submit an official application, you'll do so directly with the lender of your choice. You'll need to provide information about yourself, your home and your existing mortgage loan.

You'll also need to provide documentation for various aspects of the application. Potential documents include:

  • Recent pay stubs
  • W-2 forms
  • Bank statements
  • Tax returns
  • Business income statements
  • Investment account statements
  • Alimony and child support information, if applicable
  • Copy of your government-issued photo identification
  • Proof of legal U.S. residency
  • Sources of funds
  • Gift letter that explains you don't need to pay back gifted cash, if applicable

On average, this process can take 48 days from the date of the application to the closing date, according to ICE Mortgage Technology, a company that works with lenders. However, some lenders promise faster closing times.

5. Close Your Loan

Once the lender is ready to close the loan, you'll come together and sign paperwork to make everything official. Then, the lender will pay off your original loan and open an account for your new loan.

If you're getting a cash-out refinance, you'll receive the cash in the form of a check or wire transfer.

5 Reasons to Refinance a Mortgage

There are several reasons homeowners choose to refinance their mortgage loans. Here are some of the top ones to think about:

  1. Lower interest rate and payment: If your credit has improved or market rates have dropped since you got your first loan, you may be able to save money on interest with a lower rate and monthly payment. You can do this through what's called a rate-and-term refinance loan.
  2. Change rate type: Another option with a rate-and-term refinance is to switch your loan from an adjustable rate to a fixed rate, which can help you avoid the impact of market fluctuations.
  3. Change the loan term: You can typically qualify for a lower interest rate if you shorten your loan term from, say, 30 years to 20 or 15 years with a rate-and-term refinance. Doing so can also save you money on interest over the life of the loan but will often mean higher monthly payments. If you lengthen your loan term, on the other hand, you can potentially lower your monthly payment.
  4. Get cash out of your home: If you have significant equity in your home, you may be able to use a cash-out refinance to tap some of your equity. Homeowners may do this to consolidate debt, finance a large purchase, invest or buy out an ex-spouse in a divorce.
  5. Pay down your balance: A rare refinance option is what's called a cash-in refinance. Instead of taking cash out, you'll refinance your loan and put cash into it to pay down the balance. You may consider this if you're underwater on your loan or want to get rid of private mortgage insurance.

Downsides of Refinancing a Mortgage

As you consider your reasons for refinancing your mortgage loan, it's also important to consider the pitfalls of the process, including how refinancing can affect your credit. Here's what to think about before you start the process:

  • More interest: Lengthening your loan term can result in paying more interest over the life of the new loan.
  • Potential for higher payment: Cashing out a portion of your equity will result in a higher loan amount on your new mortgage loan, which could increase your monthly payment.
  • Closing costs can be expensive: If you plan to sell your home before you break even on closing costs, it might make sense to stay put with your current mortgage.
  • Market conditions can affect your options: There's no guarantee you'll get better terms on the new loan. This is especially true during periods of rising interest rates.
  • Hard inquiries can impact credit: Applying for a mortgage loan will result in a hard inquiry on your credit report, which can temporarily knock a few points off your credit scores. Multiple credit inquiries in a short period—usually 14 to 45 days—typically only count as one on your credit report. But if you rate-shop over the course of a few months, your scores could drop from several inquiries.
  • Affects length of credit history: This credit score factor, which makes up 15% of your FICO® Score , could take a hit when your old mortgage loan is closed and replaced with a brand new one.
  • Missing a payment could hurt your credit: Your credit score could drop if you miss a payment on your old loan during the refinancing process. Be sure to keep making payments until your old loan has a zero balance.
  • Loan starts over: You'll be replacing your current mortgage loan—and any time you have left until it's paid off—with a brand new mortgage. Depending on how long you've had your current mortgage and how long your new mortgage will last, you're likely extending the amount of years you'll be making mortgage payments.

Keep Track of Your Credit Scores Before and During the Refinance Process

As you consider and apply for a refinance loan, it's important to know where you stand with your credit. Check your credit scores regularly to ensure you don't get blindsided by negative or erroneous information, and avoid taking out new credit before and during the refinance process, if possible. Doing this can help you get your credit ready for the process and also spot potential issues that could impact your approval until closing.