Basics of home refinancing: What you need to know

Home mortgage interest rates in the U.S. move up and down in response to market forces and economic data. When the economy is slow, mortgage interest rates are low. And when mortgage interest rates are low, many homeowners decide to refinance their fixed-rate or adjustable-rate mortgage into a new "refi" mortgage with a lower interest rate.

What is a refinance?

A home mortgage refinance is simply a new home loan that pays off your old mortgage and establishes a new monthly payment at a new interest rate.

The application process for a home refinance is similar to what you have to go through for a new home mortgage. You have to prove to the lender's satisfaction that you have a regular source of income sufficient to pay off the new loan, and the appraised value of the home must be sufficient to meet the lender's requirements for the loan-to-value ratio, or LTV.

Why should you consider a refinance?

Home mortgage refinancing can save you money if done correctly and at the proper time. The three most common reasons homeowners refinance are:

  • Lower monthly payment. Refinancing to a lower rate means your monthly payment goes down. However, not all of the difference in payment can be attributed to actual savings. Spreading out your current balance over a new term also lowers your payment, but because you're borrowing money for that longer period of time, your total costs could possibly go up.
  • Shorter loan term. By opting for a home refinance with a shorter term, you lower your total costs and pay your loan off faster. Your payment will likely increase, but that increase is offset somewhat when you refinance to a better mortgage rate. Rates on loans with shorter terms are lower than those of mortgages with longer terms. The less you pay in interest each month, the more you pay toward principal.
  • Convert home equity to cash. A cash-out refi allows you to borrow against the equity you've already built up in your home. Your new payment could be higher or lower than your current payment, depending on how much you owe on your current mortgage, how much you are borrowing, the length of the loan, and the difference in interest rates.

When should you get your home refinanced?

Most people refinance to save money. Depending on your situation and current interest rates, a refinance can save you money in two ways--lower payments to better accommodate your monthly budget, or lower interest costs through the life of the loan. If lower monthly payments help you stay in your home, it might be worth the additional interest you'll pay over the life of the loan.

A simple way of looking at this is to figure out how many months it will take for you to recoup your refi costs with the money you save each month. For example, if it costs you $2,400 to refinance and you can save $60 a month, you'll recover your refinance costs in 40 months, or a little over 3 years. If you're planning to sell your home next year, a refi is probably not worthwhile in this case.

With mortgage interest rates at all-time lows, there are plenty of good reasons to refinance. If you've been working on improving your credit score, you may qualify for a lower interest rate. If your financial situation has changed and you need to lower your payments right away, it may be a good time to refinance. If you are in an adjustable-rate mortgage (ARM) that is due for an upward rate adjustment, refinancing could be a smart move for you.