When you finance a house, you borrow money to purchase it. You get approved for a mortgage from a lender. The lender gives the seller the full amount of your mortgage principal at closing. Then you begin to pay the lender back each month, paying down the principal as well as making interest payments, according to the terms of the loan.
When you refinance, you pay off your current mortgage and replace it with a new mortgage. The house doesn’t change owners. You own the house before you refinance and you continue to own it afterwards. What does change are the interest rate and terms of your home loan.
Deciding when to refinance involves researching loans and making calculations. That’s because you typically pay closing costs when you refinance a mortgage and you want to make sure paying those costs makes sense for you. By refinancing, the total finance charges may be higher over the life of the loan.
An example of refinancing
Here’s an example of how you might refinance your home. Pretend you bought a house five years ago for $275,000. You made a $25,000 down payment and financed the rest with a $250,000 conventional mortgage which has a 4.25% fixed interest rate and a 30-year term. Because your down payment was less than 20%, your lender required you to pay for private mortgage insurance (PMI).
Today the value of that home has increased to $300,000. You’ve paid down the mortgage by $25,000 so your current principal balance is $225,000. You see lenders advertising 3% mortgage refinances rates. And you wonder if refinancing might make sense for you.
A good first step is to use a mortgage refinance calculator. The calculator shows how much you might save by lowering your interest rate after paying closing costs. After looking at the calculator’s estimate, you decide talking to your lender about refinancing makes sense. You complete a new application and provide financial documents. You read and sign documents called “disclosures” that provide information about the new mortgage you want. Your lender reviews your application, and because you meet the guidelines and requirements, approves the refinance. You sign the papers to close on your new mortgage and pay the closing costs.
You pay off your current mortgage and replace it with a new mortgage which has a 3% interest rate and principal balance of $225,000. Because your home equity increased since you bought the home, you aren’t required to pay for private mortgage insurance. You also decide to reduce your loan term and get a 15-year mortgage. This increases your minimum monthly payment but also helps you save money on interest by paying off the mortgage faster.
If you decide to keep your loan term at 25 years, then your monthly mortgage payment will likely be lower but you will probably pay more total money in interest over the life of the loan because you are paying off your mortgage more slowly.
Every homeowner’s personal circumstances are different. This story shows the journey some homeowners might take when they refinance.
How lenders decide if you qualify for refinancing
Generally speaking, homeowners with good credit scores, low debt-to-income ratios (DTI), and equity in their homes have easier times getting approved for mortgage refinances. These homeowners may also be offered lower interest rates because lenders see them as desirable customers who are likely to pay their monthly bills on time and to pay off their mortgages in full.
You don’t need perfect credit or excellent finances to refinance your home. You can still get approved for refinancing with a moderate credit score and debt-to-income ratio. You will need to meet your lender’s credit, income, and financial requirements however. Certain types of loans make refinancing easier. If you have a VA loan, the VA streamline refinance program can help you refinance with easier credit requirements and less paperwork. If you bought your home with an FHA loan, the FHA streamline refinance program also has more favorable credit terms and less paperwork.
Not every homeowner will get approved for refinancing. If you are behind on your mortgage payments or have struggled to pay your mortgage on time in the recent past, getting approved could be difficult. Having a low credit score or a higher DTI can also make getting approved for refinancing more difficult. Learn more about the minimum requirements for refinancing a mortgage.
Ask Freedom Mortgage about refinancing
Freedom Mortgage offers refinancing on conventional, VA, FHA, and USDA loans. To speak with one of our loan advisors about whether you should refinance your mortgage, please call 877-220-5533 or Get Started online.
Last reviewed and updated March 2022 by Freedom Mortgage Corporation.