How Does Refinancing Work?

What It Is

Refinancing basically means applying for a new home mortgage. When you refinance your home you are replacing your existing home loan with a new one, which may allow you to adjust the term of the loan, the interest rate, the amount of the monthly mortgage or the equity in your home. Lenders often refinance home mortgage loans in order to take advantage of lower interest rates or to free up cash for other expenses. By reducing your monthly mortgage payment or the remaining term of your loan over the long run, you can potentially save paying tens of thousands of dollars in interest.

Consider the Cost of Refinance

Once you decide to refinance your home mortgage, you might want to talk to your original lender first. You will be required to go through a credit check and verification of employment. It's always wise to request a good-faith estimate in writing from the lending institution, particularly if you talk to more than one lender. You will want to make certain that you understand all of the costs involved, as you compare lenders and the best interest rate each offers. It is important to remember that refinancing comes with loan processing costs as well. You will want to determine if any long-range savings will outweigh the expenses involved in refinancing the loan. Transaction fees and other hidden costs associated with refinance could diminish any savings over the long term. Depending on your situation, it might make more sense to take advantage of lower interest rates by refinancing your auto loan or credit card debt.

Compare Interest Rates

If you refinance with the financial institution that holds your first mortgage, ask if there are any special discounts given to established customers or if certain fees can be waived. While interest rates are important, you will want to take into account the overall cost of the loan, including loan origination fees and points. Talk to your lender about the specifics. You will want to compare interest rates using the same number of points. In general, each point you pay, or 1 percent of the loan amount, reduces the interest rate by 1/4 percent.

Ask Yourself If It Will Pay Off In the End

In order to determine whether refinancing your home mortgage will pay off in your case, ask yourself whether you can refinance at an interest rate at least 2 percent lower than what you are paying now. Remember, though, that if you pay a lower interest rate, you will have less interest to deduct from your income come tax time. On the flip side, some refinancing costs are tax deductible in the year that the refinance occurs.

Think About a Home Equity Loan Instead

If you are thinking about refinancing your home in order to consolidate other debts, you might want to consider a home equity loan instead. An equity loan allows a homeowner to borrow money by using the accumulated value of the home as collateral. While lenders typically consider a home equity loan as a low risk loan and make it easy for borrowers to get, with the recent downturns in today's real estate market, the value of some real estate actually is dropping leaving the homeowner owing more money than his or her property is worth.