What does it mean to refinance a home?

A typical mortgage can take several decades to pay off. That’s a big commitment to make, especially considering how much life changes over time. Elements that used to work well might no longer fit your current situation; your goals and interests may shift. 

The same is true of your mortgage. Luckily, as with many other important aspects of your life, you can change this, too, by refinancing your mortgage. We’ll explore what it means to refinance a home in this article. 

What does it mean to refinance a home?

Simply put, refinancing your home means replacing your current mortgage with a new one, usually to get more favorable terms.

In doing so, you can potentially secure a lower interest rate, reduce monthly payments, change the loan’s length, or switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage. Additionally, you can tap into your equity to fund things like home improvements, debt consolidation, or major expenses. 

When you refinance, the new loan pays off your existing mortgage, and you begin making payments on the new loan instead.

Types of refinancing

The implications of refinancing your home can be very different depending on the type of loan you’re using. Let’s take a look at how the different refinancing options work. 

Rate-and-term refinance

A rate-and-term refinance lets you change your mortgage’s term length and/or interest rate. For example, extending the loan term can lower your monthly payments, while shortening it may help you pay off your home faster. Your interest rate could also go up or down, and you can also change from an adjustable-rate loan to a fixed-rate loan, or vice versa. 

All of these factors let you adjust how much you pay each month for your mortgage. That, in turn, affects how much interest you’ll pay over time and how long it will take to pay off your loan. 

Cash-out refinance

Homeowners can also get a new interest rate and/or term length with a cash-out refinance, but with an added twist: they can borrow additional funds, too, by taking out a larger overall loan. The old loan will be paid off with the new funds, with the leftover amount being distributed to the homeowner. 

Lenders typically charge slightly higher interest rates on a cash-out refinance loan because they’re considered somewhat riskier, on account of the larger loan amount and longer term length. 

Cash-in refinance

Cash-in refinances are a lot rarer, but if you’ve recently come into a windfall of cash, they’re worth looking into. In a cash-in refinance, you’ll take out a new refinance loan, but make an additional lump sum payment to lower your overall loan balance. By doing so, you can get a lower monthly payment. It’s the opposite of a cash-out refinance, as the name implies. 

Pros and cons of refinancing

If you understand the benefits and drawbacks of refinancing your home, you can get a better handle on whether it’s an appropriate option for your situation. 

Refinancing pros

• Get a better mortgage: Refinancing your mortgage gives you a unique chance to secure a more affordable payment, improve your loan terms, or work with a new lender.
• Change interest rate type: If your existing mortgage has an adjustable rate, refinancing to a fixed-rate mortgage can help you freeze your monthly mortgage payment in place. 
• Potentially save money over time: If you refinance for a shorter term length and/or a lower interest rate, you could save thousands of dollars over the life of your loan. 
• Borrow against home equity: You can tap into your equity for whatever you want, such as renovating your home, paying off credit cards, or starting a new business. 
• Get rid of FHA mortgage insurance: These loans are popular with those who might not yet qualify for conventional mortgages, but often come with increased lifetime costs from mortgage insurance, which you can remove by refinancing into a conventional loan once you’re able to qualify.

Refinancing cons

• You will pay additional fees: Typical closing costs range from 2% to 6% of the loan. In addition, if your new loan results in you having less than 20% equity in your home, you may have to pay additional costs for mortgage insurance.
• Spend time securing financing: Typically, it takes between one and two months to complete. 
• Must meet lender requirements: Each lender is different, but you’ll generally need at least 20% equity in your home to get approved for a new loan, as well as a credit score of at least 620 and a debt-to-income ratio (DTI) below 43%. 
• Can be more expensive over time: Extending your home loan term length often means you’ll pay more total interest over the life of the loan. Sometimes, that’s true even if you’re able to secure a lower interest rate, which can be a rude shock for homeowners who think they’re saving money with a lower rate.
• Risk an underwater mortgage: If home values drop, you could owe more than your home is worth, making it difficult to sell or refinance your home in the future. 

Should I refinance my home?

Whether it makes sense to refinance your home depends on your financial situation, and only you can determine whether it’s the right choice for you. Here are some scenarios, however, when it might make sense: 

• You want to cash out your home equity and replace your current mortgage at the same time.
• Interest rates have dropped since you took out your first mortgage, meaning you could save money by refinancing. 
• You’ve used a mortgage refinancing calculator to compare your options for monthly payments and total interest paid.
• You want a lower monthly payment, and you’re willing to extend your loan payoff date and pay more interest over time to get it.
• Your credit score, income, and/or debt load have improved since you first took out your mortgage, meaning you may qualify for a better mortgage.
• You’ve calculated the break-even point to see whether you’ll save more in interest over the long run than what you’ll pay in closing costs for the new loan.

Alternatives to refinancing

Refinancing your home is one of the most common ways to change your home debt, but it’s not the only way. Here’s how a few similar options compare:

• Loan modification: Lenders sometimes voluntarily offer struggling homeowners an option to change their loan’s term length, interest rate, or loan amount through a loan modification, which has the same effect as refinancing your mortgage without going through the whole process. 
• Mortgage recast: If you have a large lump sum that you can put toward your mortgage, many lenders will allow you to recast your loan for a relatively small fee. This spreads out your remaining balance over the same number of months you have left on your loan, so that each payment is more manageable without the need for a total refinance. 
• Home equity loan: If you want to cash out your equity but leave your existing mortgage in place, a home equity loan could work better. Technically speaking, it’s considered a second mortgage. 
• Home equity line of credit: HELOCs are another type of second mortgage, allowing you to borrow against your home equity without needing to touch your primary mortgage. A HELOC, however, is more flexible because it allows a much longer window for you to borrow money and more options for making payments. 
• Home equity investment: An HEI provides a lump sum in exchange for a share of your home's future appreciation. There are no monthly payments. You’ll typically repay the investment in thirty years, along with a percentage of your home’s equity appreciation. Unlike traditional equity products, HEIs have no income requirements, and you don’t need great credit to qualify.  

Frequently asked questions

What is the purpose of refinancing a house?

Homeowners often opt to refinance their home if they’re looking to save money, either by getting a lower monthly payment or by paying less interest over the course of their loan. Some homeowners refinance their homes when they’re looking to borrow funds, too. 

Is it ever a good idea to refinance your house?

It depends on your goals. Refinancing helps many people secure a lower monthly payment, save money on interest, or cash out their home equity. Depending on how your new loan is structured, you could end up with a higher monthly payment or owing more interest over time, though. It’s a good idea to explore alternatives like second mortgages and home equity investments to be sure it’s right for you.

Do you get money when you refinance?

Whether or not you get money when you refinance depends on the type of refinance you’re doing. A simple rate-and-term refinance doesn’t modify the loan amount, so you won’t get money back. If you choose a cash-out refinance, however, you’ll receive money back since you’re taking out a larger loan. 

Final thoughts

Understanding what it means to refinance a home can help you decide if it’s the right option for you. A good first step is to explore your options with your current mortgage lender and gather rate quotes on other refinance loans. This can help you determine what’s realistically possible, which you can then compare to your budget and financial priorities. It’s also worth consulting a financial advisor or credit counselor, too, just to be sure. 

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