How to Refinance Your Home: When to Do It and What Your Options Are

How to Refinance Your Home: When to Do It and What Your Options Are

James A Thom | Sr. Loan Officer
Fairway Mortgage
Published on November 25, 2022
How to Refinance Your Home When to Do It and What Your Options Are

How to Refinance Your Home: When to Do It and What Your Options Are

When is it a good idea to refinance?

Deciding whether to refinance your home should "depend on your goals and purpose of the refinance," says James A Thom, a mortgage adviser with Fairway Independent Mortgage Corporation in South Boston, Mass. (Fairway owns Home.com.)

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Most people refinance for one or more of the following reasons:

  • A lower interest rate: A lower rate can mean a reduced mortgage payment and less money paid over the life of the loan
  • A different loan term: Even if your rate stays the same, a longer mortgage term can lower your monthly payments since the principal is spread out over a longer period of time. Conversely, refinancing to a shorter term raises your payment but saves you money on interest
  • Take cash out against your equity: Equity is your home value minus your current loan balance. A refinance can allow you to borrow cash against your equity, and you can use the money for any purpose
  • Switch to a fixed-rate mortgage: If you took out an adjustable-rate mortgage (ARM) and are concerned about rates increasing, you can refinance to a fixed-rate mortgage to stabilize your housing costs
  • Eliminate mortgage insurance: If you have a conventional, USDA, or FHA loan with mortgage insurance, you can often refinance to a conventional loan without private mortgage insurance once you have 20% equity in the home

It's possible for a refinance to accomplish all of these goals at once: A new loan could lock in a lower, fixed rate, change your loan term, unlock cash back from equity, and eliminate mortgage insurance.

But achieving only one of these goals is reason enough to refinance.

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Still not sure whether refinancing is the right move?

"Sit down with your trusted mortgage advisor and they can break down each scenario for you on why it does or does not make sense to refinance," Seney suggests.

How does a mortgage refinance work?

All refinance loans have one thing in common: They replace your existing mortgage with a new one. When you close on the new loan, your current mortgage gets paid off, and you start making payments on the new loan.

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You may receive mailers that claim you can "reduce your rate instantly" or even "reduce the rate on your existing loan." Typically, these are just offered to replace your existing loan with another one.

Whatever the offer, the new mortgage should improve your situation. What can a new mortgage offer that your current one can't? That depends on the type of refinance you're getting.

Types of refinance loans

Rate and term refinance

This refers to a refinance where you will change your rate, term (loan length), or both.  For instance, if you have a 30-year mortgage, you could refinance to a 15-year to save on interest long-term. Or, you can refinance to another 30-year mortgage at a lower rate. By extending the repayment period, you may be able to reduce your monthly payments, making them more manageable.

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However, you'll want to make sure you're actually saving money with the refinance. A refinance is generally worth it when you can recoup your closing costs with interest savings in about 2 years. More on this below

Cash-out refinance

With a cash-out refinance, you borrow against the equity you've built up in the home - you're taking "cash out" of the house. You can use these funds however you choose. The drawback is that the new mortgage loan will be larger than your current one, and it will take longer to pay off

Streamline refinance

This special type of refinance works only if you have a government-insured loan such as an FHA, VA, or USDA loan. Streamline refinances are similar to standard rate-and-term refinances except with less red tape. In many cases, you can refinance for a lower rate or longer term without a credit check or home appraisal with a streamline refinance (assuming you are refinancing to the same type of loan)

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"The most common reason to refinance is to lower your rate and payment," says Craig Tashjian, a senior mortgage consultant with Fairway in Newton, Mass.

But changing your loan's term is a big deal, too.

"If you took out a 30-year term the first time, you don't necessarily take out a new 30-year loan," Tashjian says. "If you've had your mortgage for several years, you may consider reducing your term to a 15- or 20-year mortgage to pay it off quickly."

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A shorter loan term can save you a lot of money in the long run, but it will usually come with higher monthly payments.

How long do you need to be in a home before you can refinance?

Some loan types require waiting periods before a refinance. To replace a VA loan with another VA loan, for example, you'd need to wait at least six full monthly payments have been made. The FHA has a similar rule.

Even if your loan and lender don't require a wait, you may be short on another requirement: equity. Most refinance lenders want to see at least 20% equity built up in your home before you refinance.

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For example, if your home is worth $300,000 but you owe $270,000, you'd have $30,000 in equity, which is only 10%. That's not enough for most refinance loans. If you can refinance, it will come with new mortgage insurance, potentially negating any savings. Some lenders will make exceptions to this 20% rule for borrowers who have excellent credit.

But streamline refinances are different. With an FHA streamline or VA streamline refinance, you can refinance with little or no equity - or even be underwater - and still be approved (often with no appraisal, no income verification, and no bank statements, depending on the program).

Equity is a particular requirement for cash-out refinances, since you need a certain amount of equity to borrow against, and most loan programs will not allow you to borrow against the full value of your home. That means you need enough equity to borrow against, with a buffer amount left over.

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The VA cash-out refinance is an exception to the rule. The VA lets qualifying veterans and active-duty servicemembers borrow up to 100% of their home's value.

How many times can you refinance a home?

There's no limit on how many times you can refinance. But it's not something you'll likely want to do often.

Why? For one thing, you'll pay closing costs each time you refinance. These costs tend to range from 2% to 5% of your loan amount.

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For a $200,000 refinance loan, closing costs would range from $4,000 to $10,000 - not a fee most homeowners want to pay over and over. Even a "no-cost refinance" isn't really no cost, as these fees get translated into a higher mortgage rate. This brings us to another risk when you refinance too many times: Paying too much interest.

Each refinance hits the reset button on your mortgage interest. Since 30-year, fixed-rate mortgages front-load the interest into the earliest years of the loan, refinancing too often means you're constantly starting over instead of gaining traction to pay down your principal.

Plus, the savings from a refinance build gradually, month by month and year by year, as you make the new loan's lower payments. Refinancing again pulls the plug on the savings you were set to accrue.

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How do you know if refinancing is the right decision? Know your 'break-even point

To know whether you should refinance, you'll need to compare your new loan's cost to its potential for savings.

For example, if you'd pay $6,000 in closing costs but save $30,000 in interest over the life of your new loan, refinancing is probably a good idea.

But, remember: That $30,000 in savings will happen gradually. In this scenario, on a 30-year loan, you'd be saving about $83 a month. At $83 a month, you'd need to make payments on the new loan for six years to recoup the $6,000 you spent on closing costs.

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This time needed to recoup your closing costs is called your "break-even point."

Refinancing into a shorter loan term is a great way to get to your break-even point a lot faster, though a shorter loan term will require a higher monthly payment.

Make sure you don't plan to move or refinance again in the next couple of years. Set a goal to recoup your closing costs in about two to three years. Longer than that, and statistically most people will not have the mortgage long enough to enjoy real savings.

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How to refinance your home: General qualifications

Qualifying for most refinance loans will resemble qualifying for your original mortgage. You'll need to meet your loan's:

  • Minimum credit score requirements: Refinances often require slightly higher credit scores than your original mortgage. For example, you may need a 640 instead of a 620 for a conventional refinance
  • Debt-to-income ratio (DTI)*: DTI is your lender's way to see whether you can afford your loan's new monthly payment. Your maximum allowable DTI will vary some by loan type, usually between 36% to 45%
  • Home equity or loan-to-value ratio (LTV): When you took out your current mortgage, you likely made a down payment. With a refinance loan, you don't need a down payment, but you may need a certain amount of equity, usually at least 20%. Your lender may use the term loan-to-value ratio, or LTV, instead of home equity. A home with 20% equity has an LTV of 80%

As mentioned above, a streamline refinance such as the FHA Streamline, can help you bypass these requirements if you currently have the same type of loan.

Refinance loan options

There are a number of different refinance loans in the market. The right one will depend on your current loan, your goals for the refinance, your home's value, and how much equity you have in the property.

  • Conventional rate-and-term refinance: Resets your current mortgage balance at a lower rate, a different loan term, or both
  • Conventional cash-out refinance: Allows you to borrow cash against your equity in the home. You receive the cash as a lump sum and can use it however you choose. The new loan balance will include the remaining principal on your current mortgage, plus the amount you took out against the equity
  • FHA streamline refinance: The big benefit to this program is that you can refinance with no appraisal, you don't need equity, and you don't have to supply income documentation. But, you have to replace an existing FHA loan with another FHA loan that has a lower rate, a lower monthly payment, or both. If your current loan is less than three years old you may receive a refund on the upfront FHA mortgage insurance premium you paid, and it will be credited to your new loan
  • FHA cash-out refinance: You can replace any mortgage type with an FHA-backed cash-out refinance loan. FHA loans typically have lower credit score requirements than conventional loans. However, FHA loans require upfront and annual FHA mortgage insurance premiums, and the ongoing requirement lasts for the life of the loan
  • VA streamline refinance: This loan is the easiest one to complete of them all. With no appraisal, income documentation or bank statement requirements, these are typically simple and quick to complete. It replaces an existing VA loan with a new one. The new loan must offer a tangible benefit such as a lower monthly payment, a lower interest rate, or both. You can also use these loans to borrow up to $6,000 against your home equity to pay for energy-efficient home improvements
  • VA cash-out refinance: Eligible VA borrowers can borrow up to 100% of their home's equity with a VA cash-out refinance loan. This is an option even if their current loan is not a VA loan
  • USDA refinance: The USDA offers two refinance options: a streamline refinance for current USDA borrowers, and a rate-and-term refinance available to eligible borrowers who may currently have a different loan type
  • Jumbo refinance: If your loan balance exceeds the annual conforming loan limit, which is $647,200 for most areas in 2022, you'll need a non-conforming, jumbo refinance loan to cover the high balance

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James A Thom | Sr. Loan Officer
Fairway Mortgage James A Thom | Sr. Loan Officer
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