What is exactly refinancing and how does it work in mortgage? Understand the pros and cons of refinancing
Whether refinancing your mortgage is a good idea will depend on your financial situation. It does, however, have the potential not only to lower your monthly payments but also to secure a better interest rate. While there are many possible benefits, there are also risks.
This is part of our client education series. Send this article along to clients who have been working on figuring out whether they should refinance their home.
What does a refinance do?
Refinancing essentially means getting a new mortgage to repay your old mortgage. The reason most people would refinance their mortgage is for a new principal and a different interest rate. Because the lender would use the new mortgage to pay off the old mortgage, you are basically left with one loan and one monthly mortgage payment.
There are a few reasons why you might want to refinance your home, such as using a rate-and-term refinance to secure an interest rate—and/or monthly payment—that works better for you or using a cash-out refinance to utilize your home’s equity. Another example would be to remove a co-signer from the mortgage, which is a common occurrence in divorces.
Read next: Steep drop in refinance activity, report shows
Steps to refinance
While it is usually more straightforward than purchasing the property, refinancing includes a similar process:
Application. The first step is to figure out which type of refinance will be best for your situation. The questions surrounding your income, credit score, debt, and assets will be the same questions you were asked when you purchased the property. Additional documents may be required if your spouse is on the loan or if you are self-employed.
Interest rate. Once approved, you may have the option to lock in your interest rate to prevent it from increasing prior to the loan closing. These rate locks typically last between 15 and 60 days, but the specific period will depend on factors such as your lender, the loan type, and your location. Since your lender will not have to hedge against the housing market for as long, you could secure a better rate by choosing to rate lock for a shorter period.
Underwriting. Your lender will start the underwriting process after you have submitted your refinancing application. During this step, your lender will verify both your financial information and the details of the property, as well as conduct an appraisal to determine the value of the property. Since this step will determine which options are available, it is a critical part of the process.
Home appraisal. Like when you initially purchased your home, you will get an estimate of the value of your home from an appraiser. For this step, you should make sure your house looks its best, even down to the simplest tasks like tidying up and finishing minor repairs. If the estimate is lower than expected, you can pivot by decreasing the amount of money you want to get.
Closing. After the appraisal, you can close your loan, should you decide to. You can view the final numbers on the loan after your lender sends you a document entitled a closing disclosure. Closing in this case will take less time than when you bought the home initially.
Remember: the steps to refinancing do not differ that much from the initial purchase of the property. While less complicated, you will still need to apply, lock in your interest rate, undergo the underwriting process, get a home appraisal, and close on the new loan.
Read next: Risky cash-out refinance loans now double in volume
Why would you refinance your house?
Here is a breakdown of the common reasons homeowners refinance their mortgage:
Lower interest rate. This is arguably the most popular reason homeowners opt to refinance, since it has the potential for big savings over the life of the loan. Some factors that may have improved your position include a change in the market or an improvement in your credit.
Different type of loan. It is very possible that an adjustable-rate mortgage is better suited to your situation than a fixed-rate mortgage, for instance. You may want to switch to a conventional loan to stop paying FHA mortgage insurance. When you refinance your mortgage, these types of options become available to you.
Equity. Refinancing is not only about saving money; it can also give you better access to money. For example, cash-out refinancing lets you leverage the equity you have accumulated to borrow more. While it can add to your debt, it will also allow you to get the funds for larger expenses, such as paying for college tuition for your kids or finally finishing that home improvement project. Not only that, but it is often at a lower interest rate.
Shorter loan. Say you have a 30-year mortgage and 20 years left on it. Refinancing to a 15-year loan could provide you with long-term savings. In this case, your monthly payments may increase, but you will pay off your property quicker.
If you are looking for a lower interest rate, a different type of loan or a shorter loan, or more equity, then refinancing your mortgage may be a good option for you.
Different types of refinancing
There are many different types of refinancing options available. The type of loan you the borrower will choose ultimately depends on your needs. Some of the different types of refinancing options include:
This type of refinance changes the loan term (or repayment length), the interest rate, or both. Rate-and-term refinancing usually reduces the monthly mortgage payment or saves money on interest. Unless you incorporate a portion of the closing costs into the new loan, the money you owe usually will not change.
In this case, you are using your house to draw cash out to then spend. While this option usually increases your mortgage debt, it also provides you with the funds to invest in goals such as a home improvement project, for instance. During cash-out refinance, you can also secure a new interest rate and loan term.
Read more: Cash out refinance: Definition and how it works
Here, you would make a payment in a lump sum to reduce your LTV (loan-to-value ratio). This usually reduces your debt burden and your monthly payment and may help you get a lower interest rate. Before choosing cash-in refinancing, you should make sure paying a lump sum makes sense for you financially, rather than depriving you of better opportunities.
While rate-and-term, cash-out, and cash-in refinancing are the more common types, there are others, such as no-closing-cost refinance, short refinance, reverse mortgage, debt consolidation refinance, and streamline refinance, to name a few. Before committing yourself, it is important to know which will work best for your financial situation.
What are the risks of refinancing your home?
Before refinancing your mortgage, it is important to weigh the risks and benefits to make sure it is right for you.
It makes no sense. Make sure the interest rate on your new loan is at least 1% less than your current mortgage. If you have not had enough time to accumulate much equity, then this is especially true.
Cashing out too much. Make sure you do not leverage too much money out of the equity of your home. You may run the risk of paying too much in monthly mortgage payments and having no leeway if property values drop.
Refinancing too often. Just because you technically can refinance, it doesn’t necessarily mean you should. If you refinance too often, you can lose your savings by paying too much in fees and closing costs. Think long-term.
Read next: How a DSCR loan can benefit new and seasoned property investors
While we have touched upon many of the pros already in this article, here is a list to summarize:
- Lower interest rate.
- Lower mortgage payment, freeing up space in your monthly budget.
- Reduced loan term to pay off faster.
- Freeing up home equity.
- Consolidate debt.
- Change from a fixed-rate mortgage to an adjustable-rate mortgage (or vice versa).
- Cancel private mortgage insurance premiums.
Have experience with refinancing on a mortgage, either as a business arranging the loan or as a consumer getting one? Tell us about it in the comment section below.