How Does Refinancing a Mortgage Work?

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Refinancing a mortgage involves taking out a new loan to pay off your original mortgage loan. In many cases, homeowners refinance to take advantage of lower market interest rates, cash out a portion of their equity, or to reduce their monthly payment with a longer repayment term.

Before you start the process, however, it's important to know both the benefits and drawbacks of refinancing and how the process works.

How Does Refinancing Work?

The process of refinancing a mortgage is similar to the process of getting one in the first place. You typically start by shopping around and comparing interest rates and other terms with various mortgage lenders to see which has the best offer. Then you compare that offer with the terms of your existing loan.

If your credit has improved since you were approved for your first loan, you may have a good chance of qualifying for more favorable terms.

As you go through this process, keep an eye on the closing 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're currently paying, you'll need to stay in the home at least 50 months to make the move worth it.

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

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:

  • 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.
  • Cash out: If you have significant equity in your home, you may be able to cash out a portion of it with a refinance to pay bills, finance a large purchase, or buy out an ex-spouse in a divorce.
  • Change rate type: If your original mortgage has an adjustable rate, moving to a loan with a fixed rate can help you avoid market fluctuations.
  • Change 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. Doing so can also save you money on interest over the life of the loan. If you lengthen your loan term, you can potentially lower your monthly payment.

As you consider your reasons for refinancing your mortgage loan, it's also important to consider the pitfalls of the process:

  • Lengthening your loan term can result in paying more interest.
  • 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.
  • There's no guarantee you'll get better terms on the new loan.
  • If market rates have increased enough since you got your first loan, a better credit score may not be enough to help you score a lower interest rate.

Different Types of Refinancing

There are three general types of refinance loans you can apply for: rate-and-term, cash-out and cash-in. Here's what to know about each one.

Rate-and-Term Refinance Loan

With this type of loan, the goal is to change the interest rate, loan term or both without making any changes to the amount of the loan. This option is best if you're trying to save money on your monthly payment or switch your loan from an adjustable rate to a fixed rate.

Cash-Out Refinance Loan

As the name suggests, a cash-out refinance involves cashing out a portion of the home's equity. Doing so results in a higher loan amount, with the difference typically equal to the amount cashed out.

While a cash-out refinance can help homeowners get the cash they need for certain activities, it typically results in a higher monthly payment and interest rate than a rate-and-term refinance loan.

Cash-In Refinance Loan

Much less common than a cash-out refinance is a cash-in refinance. This happens when the homeowner refinances their mortgage loan and brings money to the table to reduce their new mortgage balance.

A cash-in refinance may be worth considering if you're underwater on your mortgage or want to get rid of private mortgage insurance, qualify for a lower interest rate, or keep your mortgage amount below certain limits.

How Do I Qualify for a Refinance Loan?

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

If you meet a lender's standards based on these criteria, you'll receive an offer according to the risk you pose to the lender. If, for example, you have a spotless credit history, a solid income and a lot of equity in the home, you may get approved for better terms on the 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.

How Will Refinancing Affect My Credit?

Refinancing a mortgage loan can affect your credit in a few ways. As a result, it's important to stay attentive to your current loan and be wise about the rate-shopping process. Here are some things to keep in mind:

  • Applying for a mortgage loan will result in a hard inquiry on your credit report, which can 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.
  • Your length of credit history could take a hit when your old mortgage loan is closed and replaced with a brand new one.
  • Your credit scores could drop if you miss a payment on your old loan during the refinancing process.

If your credit is in great shape and you keep these things in mind, you may not see much of a negative effect on your credit history. But if your credit score is on the fence between fair and good, one wrong move could make it difficult to get approved for the new loan.

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.

Want to instantly increase your credit score? Experian Boost helps by giving you credit for the utility and mobile phone bills you're already paying. Until now, those payments did not positively impact your score.

This service is completely free and can boost your credit scores fast by using your own positive payment history. It can also help those with poor or limited credit situations. Other services such as credit repair may cost you up to thousands and only help remove inaccuracies from your credit report.

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