How to Refinance Your Mortgage (Step-by-Step)

Updated: 28th Dec 2021 Written by Kim Pinnelli
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Refinancing your mortgage can be a smart financial decision, especially if you can save on interest costs.

Before you refinance your loan, learn how to refinance your mortgage and what to look for to ensure you get the best deal on your loan.

What is Mortgage Refinancing?

A mortgage refinance replaces your existing mortgage with a new loan. You could refinance to lower your interest rate, lower your payment, or take equity out of your home.

When you refinance, you either pay off your first mortgage with a new loan, or you take out a second loan, leaving your first mortgage in place.

Many loan programs offer mortgage refinancing, including conventional loans, FHA loans, VA loans, and USDA loans.

How Does Mortgage Refinancing Work?

When you apply for a mortgage refinance, you apply for a new loan, just like you did when you bought the home.

You must prove you qualify for the loan by providing proof of good credit, decent income, and a low debt-to-income ratio.

When you refinance, your new lender handles paying off your old lender. At the closing, instead of the money going to the seller like it did when you bought the home, it goes to your old lender, paying off your loan.

If you borrowed ‘extra’ money from the home because you had equity in the house, you’ll receive the difference between the new loan amount, the amount paid to your old lender, and any amount paid for closing costs.

Mortgage Refinancing Example

Here are two examples of mortgage refinancing:

John borrowed $250,000 to buy a house that was worth $300,000. John has had the loan for 10 years, but now interest rates have dropped, and John’s credit score has improved.

John finds out he qualifies for the lower interest rate, and his current loan balance is $220,000. John borrows $220,000 on the new loan at the lower interest rate. The new lender pays off the old lender, and John now makes a new (lower) mortgage payment to the new lender.

Jan borrowed $250,000 to buy a house that was worth $300,000 too. Today, Jan owes $200,000 on the home, and it’s worth $350,000.

Jan wants to make some home improvements, so she applies to borrow 80% of the home’s value or $280,000. $200,000 of this amount goes to pay off the old lender, and Jan receives the remaining $80,000 to make her home improvements.

Why Should You Refinance Your Mortgage?

There are many reasons to refinance your mortgage. It’s not a one-size-fits-all approach, but these reasons may resonate with you, giving you a reason to refinance:

  • Lower Interest Rate: Most people refinance when interest rates fall like they did this last year. With a lower rate, you have a lower payment. You can either save the money or take the difference between the new and old payment and apply it to the principal to pay the loan down faster.
  • Tap Into the Home’s Equity: Once you owe less than 80% of the home’s value, you can tap into the equity, borrowing up to 80% of the value. You can use the funds for home renovations, debt consolidation, or any other reason (lenders don’t have to approve the reason).
  • Shorten the Term: A shorter term means you pay the loan off faster. If your income situation improved or you can afford a higher payment, consider refinancing from a 30-year term to a 15 or 20-year term to pay the loan off faster. Your payment will be higher, but you’ll pay less interest and more principal.
  • Eliminate Mortgage Insurance: If you pay mortgage insurance, you can refinance and get out of it if you qualify. Typically, you need at least 20% equity in the home to get a loan with no PMI, so it pays to wait until the home appreciates and/or you pay the balance down enough to secure a loan with no mortgage insurance.

When Should You Refinance Your Mortgage?

Timing your refinance is important too. A good rule of thumb is that you may benefit from refinancing if you can save 0.5% or more on the interest rate.

Before you do, though, look at the term. It doesn’t make sense to start from scratch if you’ve had your loan for a while.

For example, if you have a 30-year term but have paid on it for 10 years, you don’t want to restart for another 30-year term.

Instead, consider refinancing into a 20-year term. You’d lower your payment, get a lower interest rate and stay on track to pay your loan off over 30 years total rather than 40 years if you started another 30-year term again.

How to Refinance Your Mortgage

Refinancing your mortgage isn’t hard nor is it difficult, but it does require a bit of work on your end. Follow our steps below to refinance your mortgage.

Step #1: Know Your End Goal

Before you refinance, think about why you are refinancing. Is it to:

  • Lower your payment
  • Get rid of PMI
  • Tap into your home’s equity
  • Shorten the term

Know your goal, so you find the program that fits your needs. If you want to save money on your payment, you should shop around for the lowest rate possible.

If you’re trying to tap into your home’s equity, you’ll want a loan with the most attractive terms for cash-out loans.

Step #2: Review Determining Factors

Just like when you bought your home, lenders will look at your qualifying factors to make sure you’re a good risk.

They look at the following factors:

  • Debt-to-Income Ratio: Your DTI compares your gross monthly income (income before taxes) to your monthly debt. The higher your DTI, the higher portion of your income that’s already accounted for. This creates a higher risk for mortgage lenders. Aim for a DTI of 43% or lower for the best results.
  • Credit Score: Your credit score is the first thing lenders look at. The higher your credit score is, the lower the risk of default you pose. Each loan program has different credit score requirements, but overall, aim for a 680 score or higher for the best results.
  • Income: You must show steady income to qualify for a refinance. Lenders like a 2-year stable job history too, but if you’ve changed jobs recently and are in the same industry, it should still count. If you changed industries and your income changed drastically, you’ll need proof of how you’ll succeed at the job (proof of schooling, training, or any other proof).

Step #3: Compare Lenders, Mortgage Refinance Rates, and Fees

Once you know where you stand, it’s time to shop for lenders. As you shop, look at the rates and fees lenders charge.

Also, compare the loan programs they offer. Not all lenders offer government-backed programs (like FHA or VA loans), and not all lenders have flexible guidelines on conventional loans.

Look at your options, know what loan programs you want to try to qualify for, and look for lenders that offer those programs with the best rates.

Step #4: Get Mortgage Loan Estimates

When you’re ready, apply for pre-approval with different lenders. If you apply for mortgage loans within a short period, the credit bureaus only hit you for one credit inquiry because they recognize the need to shop around.

Each lender must send you a Loan Estimate within 3 days of applying. Compare the estimates side-by-side to choose the loan that’s right for you.

Look at the bottom line – the loan’s total costs and not just the interest rate or payment to make sure it’s the best fit.

Step #5: Apply For Mortgage Refinance

After reviewing your options, choose the loan that makes the most sense and formally apply for it.

The lender will tell you what they need to process the loan and get you to the closing table. This usually includes income and asset documentation and an appraisal.

Step #6: Gather and Prepare Necessary Documents

After choosing a lender, you must provide the following:

  • Proof of income (W-2s and paystubs)
  • Tax returns if you’re self-employed or work on commission
  • Proof of assets (2 months of bank statements)
  • Any letters of explanation for credit issues or gaps in employment

Step #7: Prepare for Appraisal

Most lenders require an appraisal of your property unless you’re applying for a streamlined refinance with an FHA or VA loan.

The appraisal tells lenders how much the home is worth, so they make sure there’s enough collateral to fund the loan you applied for.

The appraisal evaluates your home’s size, features, location, and how it compares to homes recently sold in the area.

Make sure your home is in good condition, cleaned up, and looks presentable for the appraiser.

Step #8: Lock in Your New Interest Rates

You must lock in your interest rate when you’re ready. Lenders typically allow this once you have approval with conditions and will lock the rate for 30 days.

Once you lock the rate, that’s your rate, no matter what interest rates do. If they increase, you’re in luck – you have the lower rate.

If they decrease, you may be able to pay the lender to take the lower rate – they typically charge 0.25% of the loan amount to float down your rate.

Make sure you lock your rate in when you’re comfortable with it and won’t care if rates drop.

Step #9: Close on the Loan

The final step is to close on the loan! Unlike when you bought the home, there’s no seller to work with at the closing.

You’ll meet with a notary who will explain the documents to you – after you sign the documents, you have 3 business days to make sure it’s the right choice.

After 3 business days, the loan funds, and you have a new mortgage.

Mortgage Refinancing Pros and Cons

Pros:

  • It may lower your payment
  • You may spend less money on interest charges
  • You can free up money in your equity using it for other purposes like debt consolidation
  • A refinance can eliminate mortgage insurance
  • You can switch from an adjustable-rate loan to a fixed rate for more predictability
  • You can shorten the term to pay the loan off faster

Cons:

  • It could increase your loan term (take longer to pay off the loan)
  • You’ll pay closing costs
  • You may extend your term if you aren’t careful

Types of Mortgage Refinance

Cash-Out Mortgage Refinance

A cash-out refinance is a loan for an amount higher than the amount you originally borrowed. It allows you to tap into your home’s equity (usually up to 80% of the home’s value).

You can use the difference for anything from debt consolidation to home improvements or anything else.

Cash-In Mortgage Refinance

A cash-in refinance is the opposite of a cash-out refinance. Instead of taking cash out, you bring cash to the closing.

This option is common when you want to cancel PMI or want to secure a lower interest rate.

Most lenders require a low loan-to-value ratio to get the lower rates, so a cash-in refinance may be just what you need.

Rate-and-Term Refinance

A rate-and-term refinance is just as it sounds. You refinance your loan to get a better rate or term.

It doesn’t offer cash-out – the main purpose is to shorten the term, lower the rate, or in some cases, lengthen the term to lower the payment to make it more affordable.

Should I Refinance into Another 30-Year Fixed-Rate Mortgage?

If you have a 30-year loan and you’ve had it for a while, refinancing into another 30-year term typically doesn’t make sense.

It’s best to find a lender that offers flexible terms, allowing you to match the term you have left.

Adding years back onto your term only adds more interest to the loan and extends the time it takes to pay off your loan.

How Much Does Refinancing a Mortgage Cost?

Just like when you bought your home, the costs vary by lender.

On average, lenders charge around 3% of the loan amount, but you may find lower fees by shopping around. Before you refinance, make sure it makes sense to do so.

Look at the cost of refinancing and determine how many months of savings it will take to make up the costs. If it takes too long to pay off the closing costs, it may not be worth it.

How to Get the Best Mortgage Refinancing Rates

The best way to get low mortgage refinancing rates is to perfect your qualifying factors. This includes:

  • Maximizing your credit score
  • Stabilizing your income
  • Lowering your debt-to-income ratio
  • Having as much equity in the home as possible

Is It Safe to Refinance a Mortgage?

When you work with reputable lenders, it is safe to refinance your mortgage. Do your research and make sure you’re working with a reputable lender who offers quality programs.

Don’t provide your information until you know the lender is legit and safe.

Bottom Line: How to Refinance Your Mortgage

Refinancing your mortgage or second mortgage makes sense when it is done right and all factors are considered. Before you refinance, look for the best program with the lowest rates and best terms.

Look at your loan options and choose the loan that allows you to pay the fewest costs and pay the loan off as early as possible.

Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer , Editor, & Product Analyst with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been a professional writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Kim is committed to helping people take charge of their personal finance. Her areas of expertise spans mortgages, credit cards, credit, and loans.