Key takeaways

  • A refinance pays off your existing mortgage with a new loan that has new terms and new closing costs.
  • The break-even point, closing costs divided by monthly savings, shows how long it takes to recover what you spend.
  • A lower monthly payment is not always a lower total cost. Starting a new 30-year term can add interest over time.
  • A cash-out refinance turns home equity into new debt secured by your home.

Refinancing replaces the mortgage you have with a new one. Done for the right reasons and at the right cost, it can lower what you pay, change the shape of your loan or let you use some of the equity you have built. It is never free, though, and a refinance that looks attractive on the monthly payment can still cost more over time. This guide sets out the questions to work through before you apply.

What a refinance is

When you refinance, a lender makes you a new loan, the proceeds pay off the old one, and you begin making payments under the new terms. You go through much of the same process as when you bought: an application, a Loan Estimate, underwriting, often an appraisal, a Closing Disclosure and a closing.

Refinances usually fall into three groups:

  • Rate-and-term: changes the interest rate, the term or both, without taking cash out.
  • Cash-out: a larger loan than you currently owe, with the difference paid to you.
  • Streamlined: programs for existing FHA and VA borrowers, such as the FHA Streamline and the VA Interest Rate Reduction Refinance Loan, which can involve less paperwork.

Common reasons people refinance

  • To get a lower interest rate than the one they have.
  • To shorten the term, for example from 30 years to 15, to pay the loan off sooner.
  • To move from an adjustable rate to a fixed rate before an adjustment.
  • To remove mortgage insurance, such as by moving from an FHA loan to a conventional loan once there is enough equity.
  • To remove a borrower from the loan, for instance after a divorce.
  • To borrow against home equity for a major expense.

What refinancing costs

Closing costs on a refinance resemble those on a purchase: origination charges, appraisal, title services, recording fees and more. A loan advertised as having no closing costs usually recovers them another way, through a higher interest rate or by adding them to the balance. Also check whether your current loan has a prepayment penalty.

The break-even test

The simplest first check is to divide your total closing costs by your monthly savings. If a refinance costs $6,000 and lowers your payment by $200, you need 30 months, two and a half years, just to get back to even. If you expect to keep the home and the loan well past that point, the numbers may work. If you might move sooner, they may not.

Look at total cost, not only the payment

Resetting the clock is the trap most often missed. Suppose you are ten years into a 30-year loan. A new 30-year loan spreads what you still owe over 30 more years, so the payment drops, partly because repayment now stretches four decades from when you first borrowed.

Illustrative example: ten years into a $300,000 loan at 6%
Remaining balance / current payment
about $251,057 / $1,798.65
Total of remaining payments if you keep it
about $431,676
New 30-year loan at 5.25%: payment / total
$1,386.35 / about $499,085
New 20-year loan at 5.25%: payment / total
$1,691.73 / about $406,016

Hypothetical rates; principal and interest only; closing costs not included. For illustration, not a quote.

In this example the 30-year refinance lowers the payment by about $412 a month yet adds roughly $67,000 in total payments. The 20-year option saves less each month but reduces the total. Neither is automatically right; the point is to see both numbers before deciding.

A closer look at cash-out refinancing

A cash-out refinance can fund repairs or other large costs, often at a lower rate than unsecured borrowing. But it converts equity into debt, resets your loan and is secured by your home. Lenders limit how much of your equity you can borrow. It is worth asking whether the purpose would still make sense if the money had to be repaid over the full term of the new loan.

Be wary of pressure

Treat unsolicited refinance offers with care, especially any that urge you to act immediately or ask for fees before you have received a Loan Estimate. A legitimate lender will put its terms in writing on the standard form.

The steps, in order

  1. Define your goal: a lower payment, a shorter term, a fixed rate, removing insurance or cash out.
  2. Check your credit and estimate your equity using a realistic view of your home’s value.
  3. Request Loan Estimates from several lenders on the same day, for the same loan.
  4. Run the break-even and total-cost math for each offer.
  5. Lock your rate, submit documents and complete the appraisal if one is required.
  6. Review the Closing Disclosure, which you should receive at least three business days before closing.

For many refinances of a primary residence, federal law also gives you three business days after closing to cancel the transaction. Your closing documents explain how that right works for your loan.

Helpful official resources

About this guide. OwnMG publishes general educational information. It is not financial, legal or insurance advice, and OwnMG is not a lender, insurer, broker or government agency. Rules, limits and fees change, so confirm current details with your lender or the agency involved. Spotted something out of date? Tell us at info@ownmg.com.