Undoubtedly you’ve seen ads encouraging you to refinance your mortgage. These ads promise to “lower your monthly payment” or “tap into your equity” — without really explaining what a refinance is.
The steps to take out a mortgage when you purchase a home can be overwhelming. A refinance has many of the same steps. It might make you wonder if a refinance is worth the effort and associated costs.
A refinance is for people who already have a home loan and can often save you money or help you achieve other financial goals. However, the benefits of a refinance depend on a few factors. We’ll walk you through what a refinance is, what’s involved, and why you might consider one.
What is refinancing?
When you initially took out your mortgage, you signed an agreement with your lender for a specific loan amount, interest rate, and term. When you refinance, you replace your existing loan with a new loan, leaving you with a new monthly payment that will replace the old monthly payment.
Rate and/or term refinance
A common reason borrowers refinance is to get a lower interest rate. Interest rates fluctuate frequently, and a reduction of 0.5% or 1.0% can drastically impact how much interest you’ll pay over the life of your loan. A lower interest rate will also reduce your monthly payments.
You may also want to refinance to change the term of your loan. If your loan term was 30 years, changing the term to 15 years will pay your loan off sooner. However, your monthly payment will be higher, unless the corresponding interest rate is also substantially lower.
You can refinance for rate and term at the same time: with a single refinance, you could get a lower interest rate and change the term of your loan.
Cash-out refinance
You can also refinance and change your loan amount. Lenders will have a maximum amount they’ll lend based on the appraised value of your home. This is known as loan-to-value or LTV. If your home was worth $500,000 at the time you took out your original loan, you may have only been able to borrow $400,000.
But let’s say your home is now worth $550,000, and a lender is willing to do a loan for $440,000. In the meantime, you’ve also paid down your loan from the original amount and owe only $375,000. You could take out a new loan for $440,000, pay off the existing loan for $375,000, and the lender will give you the difference — $65,000 — in cash.
Lenders will refer to this as “tapping into your home’s equity.” The equity in your home is the difference between what you owe and what your home is worth.
When should you refinance?
It’s important to understand that a refinance has closing costs, which can be thousands of dollars. However, a refinance might be worth it, depending on what you’ll gain from the transaction.
Refinancing for a lower interest rate or shorter loan term. The amount you pay upfront for closing costs can be offset by the amount you’ll save. A lender can help you with this calculation.
You don’t have to refinance to pay your loan off sooner. Most loans do not have a prepayment penalty, meaning you won’t pay any additional fees to pay your loan off sooner. You don’t have to commit to a shorter term by refinancing your mortgage; instead, you could make extra payments each month. This gives you more flexibility if your financial situation changes and you need to return to your original, lower payment.
However, because shorter-term loans typically come with lower interest rates, it might be worth refinancing to take advantage of paying less interest.
Refinancing for a lower monthly payment. If you’re in a tight financial situation, you can also refinance and increase the term of your loan. For example, you could go from a 15-year mortgage to a 30-year mortgage. A 15-year loan might have seemed like a good idea when you initially purchased your house, but an expanding family or job change could make the higher monthly payment a burden.
A refinance to a longer term will increase the total amount of interest you’ll repay, even if the interest rate is the same. However, it might be worthwhile if it eases your monthly payments and financial stress.
You’ll also lower your monthly payments if you can secure a lower interest rate, even on a loan for the same term. If your interest rate was high on your original loan due to your credit score, and your credit score has improved, you can see if you qualify for a lower rate to reduce your monthly payment.
Tapping into your home’s equity. If your property value has increased, you can do a cash-out refinance. You can then pay down higher interest rate debt (such as credit cards), make home improvements, or use the cash for nearly anything else.
Even if your home’s value hasn’t increased, you may still be able to tap into your home’s equity. Lenders have different LTV requirements for a home purchase versus a refinance. Some lenders may only allow you to borrow 80% of your home’s value when you purchase it, but will allow 90% if you refinance, which would increase your loan amount.
Lenders in the original purchase transaction will also only lend at the lower of the purchase price or appraised value. If your home appraised for more than the purchase price, you automatically have equity you could tap into with a refinance.
A cash-out refinance isn’t the only option for tapping into your equity. You can also take out a home equity line of credit (or HELOC), which is a different mortgage product. A cash-out refinance gives you fixed monthly payments, whereas a HELOC’s payments vary depending on the balance of the line of credit. HELOC’s can also be fixed, or variable loans. Talk to your lender about which option makes more sense for you.
What is the refinance process?
Refinancing has many of the same steps as your original home purchase. The lender — a bank, credit union, private lender, or mortgage broker — can talk you through your refinancing options. They’ll let you know your new monthly payment under the new loan terms and how much cash you could potentially receive (if you’re doing a cash-out refinance). They can also let you know the associated closing costs, such as an appraisal, title insurance, and any origination or closing fees.
The application, underwriting, and approval process will be similar to the purchase process. The lender will assess your overall financial health, including your income, your other debts, and your credit score. Even if you qualified for your initial home purchase, you may not qualify for a refinance if your financial situation has changed. An underwriter will request documents from you, including paystubs, bank statements, tax returns, and more.
But unlike a home purchase, fewer people are involved. Your lender isn’t trying to coordinate with sellers, and you won’t have steps like a home inspection. Many lenders have a very streamlined process for refinancing loans. Plus, you’ll already have some of the lender’s requirements in place, like homeowner’s insurance.
Do your research before you refinance your mortgage
If you’re considering a refinance, you don’t have to use your existing lender. You can compare lenders and find the one that offers you the best loan terms.
When you refinance a loan, you are resetting your term, no matter the reason for the refinance. Let’s say you have a 15-year loan and are three years into paying the loan back. You are refinancing for a lower interest rate, and your loan term will still be 15 years. When the refinance is complete, your 15 years start over, meaning you’ll have made payments for 18 years total by the time your loan pays off. For people further into the term of their existing loan, a refinance makes less sense because you may not be able to recoup the costs.
Even though the calculations around cost savings and benefits can be complex, lenders and brokers are well-equipped to walk you through different scenarios. They can help you figure out how much interest you’ll pay and how much you’ll save. They can even factor in the savings from paying off higher-interest rate credit cards with a cash-out refinance.
It is important to work with an experienced mortgage loan officer who will outline, and explain, the benefits of refinancing. You will want to make sure that you benefit from the refinance in a timely manner, and that the refinance fits within overall financial goals.
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