The Mortgage Refinancing Process Explained
Reader question: "We are thinking about refinancing our home while interest rates are still low. I've been researching the process a little, but I'm still not clear on how it all works. Can you explain the basic process of refinancing a mortgage loan?"
It's good to see you doing so much research in advance. It will certainly make the process easier for you. Here's an explanation of what happens when you refinance your home.
Let's start with the good news. Whether you realize it or not, you already have a pretty good idea how the mortgage refinancing process works. That's because you've been through it once before, when you first bought the home. Technically, you went through a financing process -- but refinancing works in much the same way.
- The first time around, you took out a loan for the price of the home (minus whatever down payment you made).
- This time around, you are taking out a loan for the balance owed on your current loan.
In a nutshell: Mortgage refinancing is when you replace your existing home loan with a new one. The new loan basically pays off the old one. Then you'll have a new interest rate and a new set of terms. Ideally, the new rate and terms would benefit you in some way. That's the whole point of this process.
People refinance for a variety of reasons. Here are the most common ones:
- You could lower your monthly payments, either by (A) extending the payment period or (B) securing a lower interest rate.
- You could reduce the total amount of interest you pay over the life of the loan, either by (A) shortening the term or (B) securing a lower rate.
- The refinancing process could also lower your risk. You can refinance out of an ARM loan and into a fixed-rate mortgage to lower your risk and increase your stability.
- You could refinance to pull cash out of your equity. This is referred to as a cash-out refinance.
Now we know what a refinance loan is and why people use them. Let's talk about the "how" factor next. Here's an overview of the mortgage refinancing process.
Refinancing Process Overview
In reality, this process is fairly straightforward. You apply for a refi loan. The lender checks your credit score and your debt ratios, just like they did when you first bought the home. Then they send an appraiser to determine the value of your house. If you have a sufficient amount of equity, they will approve you for the loan.
But it doesn't always go so smoothly. There are plenty of obstacles that can pop up along the way. Maybe your credit score is too low. Maybe you don't have enough equity in your home. We will discuss all of these things as we work our way through the process.
Step 1 - Research and Preparation
Before you start talking to mortgage lenders, or applying for loans, you should research your financial situation. Your credit score is a good place to start. Check your FICO credit score to see where you stand. This is a critical item in the mortgage refinancing process, and for two reasons.
- First of all, it's a qualification checkpoint. Lenders will use this score (among other things) to determine if you're qualified for the loan. If your credit is bad, you probably won't get approved for refinancing. So the rest of the process is a moot point.
- Secondly, your credit score affects the interest rate you receive from the lender. The rate, in turn, will determine whether or not it makes sense to refinance your home. Getting a good rate is the key to success when refinancing. And your credit score plays a big part.
Here are more reasons to check your score before applying for a loan.
You should also find out how much you still owe on your original mortgage, and what your house is worth in the current market. These two numbers are needed to measure your equity. For example, if I still owe $300,000 on a home that is worth $400,000, I would have 25 percent equity. I have $100,000 worth of equity, which is 25 percent of the $400,000 value.
What does this have to do with the mortgage refinancing process? Plenty. If you don't have enough equity in your home, you won't be able to refinance your loan. The exact requirement will vary from one lender to the next. You will probably need 5 - 10 percent equity to qualify for refinancing. But don't take these numbers as gospel. That's what most lenders require, but there are exceptions to every rule.
Your current mortgage lender / loan servicer can tell you how much you owe on your loan. You can get a rough idea of your property value by looking at comparable sales in the area. You could also have the house appraised by a professional home appraiser, if you want a more accurate assessment of the market value. Or you could just apply for refinancing and let the mortgage lender send an appraiser out. Either way, your equity will come into the picture eventually. And it could make or break your chances of getting the loan.
Step 2 - Apply for the Loan
You should be familiar with this step in the mortgage refinancing process, because you've been through it before (on the purchase side). So there's not much to explain here. The lender will probably have you fill out the standard application, which is the Uniform Residential Loan Application. You can see examples of this document online. Just do a Google search for "Fannie Mae form 1003" or "Freddie Mac form 65."
Once you complete the application, the lender will request additional documents from you. You might remember this from when you first purchased the home. The only difference is that lenders today are asking for a lot more documentation than they did in the past. It's harder to get a mortgage loan today, due to the ongoing housing crisis. So you might be surprised at the number of documents they require. At a minimum, it will be the usual suspects such as bank statements and tax records.
3. Find Out if It Makes Sense to Refinance
Does it even make sense for you to refinance your home? A drop in interest rates doesn't necessarily mean it's a good time for a refi. You need to look at the amount of money you'll save on your monthly payments, and then project those savings over the number of years you'll remain in the home. That's the next step in the mortgage refinancing process, and it's Part 2 of our tutorial:
Disclaimer: This article explains the process you will go through when you refinance your home loan. This article is for educational purposes only. It is not meant to take the place of the mortgage pre-approval process. Only a lender can tell you if you are qualified for refinancing under their particular guidelines.
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