This resource is part of the Innovative Funding Services (IFS) educational collection on refinancing.
Learn How Mortgage Refinancing Can Affect Your Finances
Mortgage refinancing is the process of replacing your current home loan with one of different terms. In most cases, refinancing your mortgage will require you to find a new lender who will pay off your current mortgage. However, before you begin applying to new lenders, you need to understand your goals for refinancing and the ways a mortgage refinance may affect you.
While most people’s reasons for refinancing are financial in nature, the effect it will have on your finances is highly dependent on your current situation and the terms of your new home loan. Some deals will save you money in the long run but cost you more upfront. Other refinances will put money in your pocket today but increase the cost of your home over time. And still, other deals will have other widely varying outcomes for you financially. But by understanding how mortgage refinancing works you can foresee how any given deal may affect you or at least manage the risk of refinancing.
We will explore some of the common outcomes you may seek with home loan refinancing below and key factors to consider. Then, we will look at how the mortgage refinancing process works and finish with an example.
Possible Mortgage Refinancing Outcomes
Some of the most common reasons you may want to refinance your mortgage are to lower your interest rate, to switch to a fixed or adjustable rate mortgage, or to pull cash out of the equity in your home.
Lowering Your Interest Rate
Perhaps the most common reason for refinancing is to lower the interest rate on your mortgage, because when all other things are equal a lower interest rate will decrease the total cost of borrowing over the life of your loan.
When refinancing to lower your interest rate, you must also consider the closing costs, how long you intend to stay in your home, and the length of your new mortgage to understand if you will actually save in the long run.
Mortgage refinances, like mortgages in general, are expensive. Their cost comes not just from interest charges but from closing costs, or expenses on top of the price of your home such as origination fees (i.e. a fee your lender charges to create the loan), appraisal fees, title fees, credit reporting fees, and much more.
Closing costs come in two flavors: those that are part of your finance charge and those that are not. You will need to ask your lender to determine which closing costs fall into which category, but understanding the difference will help you figure out how much your mortgage will actually cost.
When you get a mortgage agreement, you will see a “Finance Charge” item. Your finance charge is the dollar amount of how much borrowing will cost you over the life of your loan. It includes both your interest charges on the amount you borrow and the closing costs that your lender considers to be part of the cost of your mortgage (e.g. possibly the origination fee), whether you pay them out-of-pocket or bundle them into your loan. So, your finance charge will include some of your closing costs. Moreover, your Annual Percentage Rate, or APR, which is the rate that you will pay your finance charge on an annual basis, will also reflect closings cost that are part of your finance charge.
However, you may also face closing costs that your lender does not consider part of your finance charge (e.g. possibly the appraisal fee). These fees will not be reflected by your finance charge or your APR. So, to get a full picture of the total cost of your loan, you must add any closing costs that are not included in your finance charge to your finance charge. For every mortgage offer you receive, ask the lender for the interest rate, APR, and total cost to close on the loan.
How Long You Intend to Stay in Your Home
Another thing to consider is your closing cost “break even” point, or the number of months it will take you to recoup your out-of-pocket closing costs from a lower monthly payment. If you do not plan to stay in your home long enough to reach your break even point, then refinancing is likely not a good option for you.
For instance, if you have an offer to refinance your home so that your payment will be $100 less per month but with $1,500 in up front costs, then your break even point will be 15 months [15 = $1,500 / $100]. In this case, you would need consider how likely you are to stay in your home for 15 months. If you sell your home before breaking even, then you would lose money from refinancing.
The Length of Your New Loan
You should also consider the length of your new loan when refinancing to a lower interest rate.
When you extend your term length, you have to pay extra months of interest charges. If your new interest rate is not sufficiently lower than your original loan, then those extra months of interest charges may increase the total cost of your home over the life of your loan. Unfortunately, mortgage refinance deals often involve extending the loan term length.
Most lenders only offer mortgages of specific term lengths such as 30-year, 25-year, 20-year, and 15-year mortgages. In many cases, borrowers looking to refinance cannot find new mortgages with term lengths exactly matching their current remaining term lengths. As a result, borrowers often extend their loan terms when refinancing.
For example, if you have paid four years of a 30-year mortgage and then refinance to a new 30-year mortgage, then you will end up paying four additional years of monthly interest charges by the end of your loan, but your monthly payments will likely fall. If your new interest rate is not sufficiently low, the extra years of interest charges will make your new mortgage finance charge greater than your previous one’s. So, extending your term length with a mortgage refinance can increase the total cost of your loan.
Similarly, sometimes borrowers equate lowering their interest rates with lowering their monthly payments, but these do not necessarily go hand-in-hand. If you lower your interest rate but increase your loan term length, your payment will likely fall, but you may also end up paying more over the life of your loan. Alternatively, if you decrease your interest rate and your loan term, then your payments may actually go up while the total cost of your mortgage, in the long run, may drop dramatically.
Switching to a Fixed Rate Mortgage or an Adjustable Rate Mortgage
Mortgages come in two types: fixed-rate mortgages and adjustable rate mortgages. If you have a fixed-rate mortgage, your interest rate is locked in for the life of your mortgage, so the only way to lower is it to refinance. With an adjustable rate mortgage (ARM), your interest rate remains fixed for a specified period of time, usually 5 to 7 years, and then adjusts in line with a benchmark interest rate periodically after that, usually annually. A common reason for refinancing is to switch from an ARM to a fixed rate mortgage or sometimes vice versa.
Refinancing an ARM to a Fixed Rate Mortgage
A big attraction of ARMs is the initial interest rate a borrower receives is oftentimes lower than those on comparable fixed-rate mortgages. ARMs are great for those who do not intend to stay in their homes for long. Additionally, these loans are attractive in an economic environment in which rates go down, because once the rate begins adjusting a borrower can enjoy lower interest rates without refinancing, avoiding closing costs.
But when rates rise, ARM borrowers sometimes feel the need to refinance to fixed rate mortgages. If you find yourself in this position, just make sure you consider the closing costs and length of your new loan as discussed in the above section.
Also, keep in mind that sometimes people refinance an ARM to a new ARM mortgage to take advantage of new ARM offers with lower initial interest rates.
Refinancing a Fixed Rate Mortgage to an ARM
As already discussed, ARMs tend to have lower initial interest rates than fixed-rate mortgages, so some borrows refinance to them for the extra savings on their payments or when they feel interest rates will decline in the future.
If you are considering refinancing to an ARM, keep in mind the risks of interest rates rising in the future. It is possible that the long-term costs of an ARM in an environment in which rates rise will outweigh the short-term savings of an initial lower rate.
Pulling Cash Out of the Equity in Your Home
For most mortgages, as you make monthly payments, you will accumulate equity, or ownership, in your loan. After a few years of payments, your equity can be worth a significant amount of money. Certain types of refinancing deals, often called “Cash-Out Mortgage Refinancing,” allow you to pull cash out of the equity in your home, but you need to be careful with such deals.
Borrowers may have many reasons to pull cash out of their homes. For instance, a borrower might use the cash to remodel his or her home, which may increase the total value of the house. Another may view pulling cash out of home equity as a way borrowing at a lower interest rate than he or she could get with a personal loan. But no matter the reason a person has, it is important to recognize that refinancing to pull cash out of home equity is not free.
Obviously, having a large amount of cash in the bank is always attractive, so cash-out refinancing is something many people do. But it comes with the downside of increasing the total cost of your home. When you cash out of the equity in your home by refinancing, you have to pay refinancing closing costs and interest charges on the portion of the home you once owned for a second time.
Laws governing cash-out refinances vary by state, so research your state’s laws and regulations if you considering pulling cash out of the equity in your home through refinancing.
The Mortgage Refinance Process
The mortgage refinance process will vary depending on your current situation and the lender you work with to refinance. Still, the process tends to follow a series of steps like the following:
- Consider your financial situation and needs – Before refinancing, you should understand your reasons for refinancing and how refinancing may affect your financial well-being, as discussed above.
- Apply to refinance – Apply with three or more reputable lenders or mortgage companies so that you will have options to compare.
- Compare Loan Offers – Consider carefully how each mortgage offer would affect you both in the short term and over the course of your mortgage. Tip: Apply for mortgages that are the same in terms of length and amount financed and then compare the interest rates, APRs, and closing costs on your loan offers (remember that not all closing costs are reflected in your APR). You want all three of these numbers to be as low as possible. If you receive loan offers with the same term length, amount financed, interest rate, and APR, the mortgage with the lowest total closing costs will be your least expensive option.
- Have Your Home Appraised – Chances are your new lender will require an appraisal of your home’s current value before closing the deal.
- Close on Your Refinance – Finally, you will close on your new mortgage. At the closing meeting, you will pay some of your closing fees (which you may not have to pay up front if they are included in your financing) and sign the mortgage documents. The mortgage refinance closing process tends to take a long time, sometimes hours, because the paperwork you have to go over and sign is usually long. Moreover, mortgage refinancing may involve many players including the closing agent who will prepare all your paperwork and a representative for the title company that will transfer your home’s title. Note: For cash-out refinances, you may not receive your funds the day of the closing because by law you have three days to rescind on the offer. Some states give you an even longer period to back out of a cash-out refinance.
You will also need to provide a number of documents either when applying for mortgages or at the closing meeting. Some of the items you may need to provide include:
- Proof of Title Insurance
- Bank Statements
- Pay Stubs
- Proof of Down Payment
- W-2s and/or 1099s
- Tax Returns
Example: Refinancing Your Mortgage
Imagine that you want to refinance your home that you purchased three years ago for $250,000, including all closing costs (i.e. we will assume all closing costs were bundled into the loan). You financed your purchase with a 30-year fixed rate mortgage at a 5% APR, giving you payments of $1,342.05. Ultimately, with the 5% APR you would pay $233,139.46 as your total finance charge over the life of your loan, making the total cost of your home $483,139.46 [$483,139.46 = $250,000 + $233,139.46] if you pay off this mortgage as scheduled.
Today, however, three years into your loan, your credit has improved and you feel your financial situation is stronger overall. So, you believe you can refinance to a lower APR and thus save on the total finance charge for buying your home.
Shopping for Your Mortgage Refinance
You apply to refinance your mortgage with three lenders, Lender A, Lender B, and Lender C. You specify during the application process that you are seeking a 30-year fixed rate mortgage.
Lender A offers you a mortgage on the balance on your loan with an APR of 4.10%.
Lender B offers you a mortgage with an APR of 4.00%.
And Lender C offers you a mortgage with an APR of 4.03%.
Since these fixed rate mortgages have the same term length of 30-years, you decide to go with Lender B’s mortgage because they offered you the lowest APR.
Note: We assume in this example that all of your closing costs for each of these loan offers are bundled into your new mortgage and that all the closing costs are part of your finance charge. Remember that your APR will reflect your closing costs that your lender considers part of your finance charge. In some cases, you may have to pay closing costs out-of-pocket. Moreover, paying closing costs up front even when you do not have to may be advisable as it lowers the total amount you borrow. However, if you do pay costs up front, ensure that you consider how many months it will take to “break even” on those costs from a lower monthly payment.
We also assume in this example that you do not have to make a down payment to refinance, although in some cases to refinance a home loan you must.
How Your Mortgage Refinance Affects Your Finances
You can follow along with this example using our mortgage refinance calculator. When inputting the values for this example, make both closing costs inputs $0.
After paying your original loan for three years, or 36 months, you still owe $238,358.99 on your home. You have made payments totaling $48,313.95 but $36,672.93 of that went to your mortgage’s finance charge. So, your new lender will pay off your $238,358.99 loan balance, making that your new amount financed.
Your new payment will be $1,137.96, giving you a monthly savings of $204.09! However, you will also be making three more years of payments that include three more years of interest charges. So, you need to look into whether you will also save on your home in the long-run.
With the 4% APR, you will accumulate finance charge slower than with your original loan, adding up to $171,307.43 over the 30 years. When you add that to the $36,672.93 you paid in finance charges during the first three years of your original loan, you get a total finance charge of $207,980.36.
Since your original loan would have cost you $233,139.46 in finance charge, you save $25,159.10 [$25,159.10 = $233,139.46 – $207,980.36] on your home in total.
The graph below (Figure 1) illustrates how your finance charge would accumulate over the course of your original loan if you were to keep it and your new loan if you refinance.
Notice how the original loan (in blue) and the new loan (in orange) each last 360 months, or 30 years. However, since you refinance after three years, the new loan line begins after 36 months at $36,672.93 on the graph. The new loan lasts for 30 years, so on the graph, it ends at month 396 [396 months = 36 months + 360 months], or 33 years after you got your original loan.
The cumulative finance charge curves are bowed so that they increase at a decreasing rate until the end of the loans. This behavior illustrates how mortgage interest works. With mortgages, you pay interest on the balance of your mortgage outstanding, so as you pay down your mortgage balance, you pay less and less in interest charge with each payment.
The bowed nature of the curves also helps explain why your finance charge savings is not equal to something like your monthly savings of $204.09 multiplied by 360 months, or $73,472.05. While your monthly savings stays the same, the amount of finance charge you pay with each payment decreases as your loan balance falls. So, in any given month your finance charge savings will not equal your monthly savings except by coincidence.
The graph below (Figure 2) depicts how your finance charge savings will actually accumulate over the 360 months of your refinance loan. For much of the loan, your savings will increase, but notice how it actually decreases near month 250. At this point in your new mortgage, your original loan would have been winding down, meaning that the finance charge associated with each payment would have fallen below that of your refinance loan. And after month 324 (month 360 on your original loan), your original loan would have ended, meaning you will pay 36 months of interest charge you would not have paid with your original loan. Still, in the end, you save $25,159.10 in finance charge.
Note: Mortgage interest works the same way as auto loan interest. For an explanation of this type of loan interest, read “How Car Loan Interest Works.”
Alternative Outcomes of Refinancing
In this example, you saved both on your monthly payment and on your finance charge. Refinancing can, however, result in many other outcomes. For instance, is not unusual for someone to refinance to a lower monthly payment only to pay more in finance charge over the life of his or her loan. This outcome is especially common when a new loan’s APR is not low enough to outweigh the extra finance charge that comes with an extended loan term. If you are not careful, extending your mortgage term length can actually cost you a great deal in the long run.
Refinancing your mortgage can put you in a better financial position. It can help you lower your monthly payments, decrease the total cost of your home, put cash in your pocket now, or achieve a combination of these outcomes depending on your new loan. However, you need to lay out your goals for refinancing, understand your current mortgage, and consider how any new loan offer you receive would affect you both in the short-term and in the long-term if you are to be successful.
Moreover, you need to consider how much time you have to invest in refinancing. Mortgage refinance can be time-consuming and stressful. It can require a great deal of paperwork and interactions with various parties including financial institutions, title companies, appraisers, and more.
Another Option: Vehicle Refinancing
If are looking for a less time-consuming way to save money every month or lower your total cost of debt, consider vehicle refinancing. Refinancing a car is generally simpler and less time-consuming than refinancing a mortgage. Learn more about automotive refinancing here.
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This resource is for educational purposes only. Its content is designed to explain concepts, not to present exact definitions or to reflect how all financial institutions, mortgage lenders, or auto companies conduct business.