How Does Mortgage Refinancing Work?

A mortgage is a loan from a bank or other lender that helps a borrower purchase real estate. The property you buy is used as collateral, so if you default on the loan, the bank can seize it and sell it to recoup some or all of its losses. A mortgage refinance trades your current mortgage for a new one. The lender pays off the old loan, and you begin making payments on the new loan.

Loan Terms

A mortgage loan term is the amount of time during which a borrower makes monthly payments toward a home loan. Most mortgages are designed to be paid off in 15 or 30 years, but other loan terms are available. Generally, mortgages with longer terms will have lower monthly payments than mortgages with shorter terms. However, the former may cost more in the long run, as the longer you take to pay off your loan, the more interest you will pay overall. Mortgages with shorter terms usually come with higher monthly payments but lower overall interest.

Interest Rates

The two main types of interest rates on mortgages are fixed and adjustable.

With a fixed-rate loan, you will pay the same interest rate for the duration of the loan. Fixed-rate loans offer predictability, as your payment remains the same even if market conditions push interest rates up. The disadvantage is that if rates fall, you can’t take advantage of potential savings.

Also known as an ARM, an adjustable-rate mortgage has an interest rate that changes with a benchmark rate, such as the prime rate. The introductory interest rate is set for a period of time, such as five years, after which the interest rate can adjust up or down, depending on market conditions. While ARMs allow buyers to take advantage of low teaser rates, they can be riskier than fixed-rate loans.

Following the introductory period, your lender will periodically recalculate your interest rate based on prevailing market conditions. Your interest rate is subject to change at predetermined intervals, perhaps as often as once per year.

The interest rates for ARMs are based on the benchmark rate of the lender’s choice