What Is Mortgage Refinancing?
Have you ever heard a commercial tell you it’s a good time to refinance your home and you should do it now, now, now!? But what does refinancing a home loan mean? What are its advantages? Are there any disadvantages? This article is here to explain the basics so you’re no longer in the dark!
Refinancing replaces your existing home loan with a new loan—from the same or a different lender—that pays off the debt of that older loan. The idea is that the new loan should have better features that help you financially.
Why someone would want to refinance
Your financial situation may have changed or perhaps the lending market has changed, which could mean you can improve your loan’s terms by refinancing. Here are some specific examples:
- You have an improved credit score. Congratulations! Now that you have a higher credit score, you’ll be able to get lower interest rates on all sorts of loans, including a new home loan to replace your old one.
- You want to do some home renovations or an addition. If you’ve been in your home a while and built up a lot of equity (the amount of your home’s value that you own by paying off your mortgage), you can do a “cash-out” refinance. What this does is give you back some of that equity value in cash for you to reinvest in the house by doing much-needed repairs or upgrades.
- Home loan interest rates have dropped. If home loan interest rates are significantly lower than when you took out your mortgage, it might make sense to refinance and take advantage of the lower rate. However, there are instances when it doesn’t make sense to refinance, even if interest rates are now lower (keep reading to see why).
- You want to get out of an adjustable-rate mortgage (ARM). If you have an ARM and the current market rates are low and your credit is strong, it can make sense to refinance into a fixed-rate mortgage, which ensures you’ll be paying that lower interest rate for the life of the loan instead of having it fluctuate with the market.
- You want to get out of an interest-only mortgage. With an interest-only mortgage, you only pay the interest on the principal amount for a set number of payments. At the end of that time, the whole amount of the loan is due in one lump sum, or you must refinance to get a traditional amortized home loan.
Refinancing can be a time-consuming and expensive process. First, you’ll need to shop around for the best rates and terms, getting quotes from multiple lenders (including your current lender). If you find a lower interest rate at a different lender, see if your current lender is willing to match it. This would cut down on the refinancing paperwork if you stay with the same lender.
Second, you’ll need to go through the refinance application process, which is similar to an initial mortgage approval process. You’ll be evaluated on your credit score and history, income and employment history, and assets and cash reserves. This will involve submitting tax returns, paystubs, etc.
Third, the home will be subject to a home appraisal to assess its current market value. Overall, the refinance process usually takes 30 days or fewer, so it is shorter than an initial home purchase.
Potential benefits of refinancing:
- Pay less interest and save money. Especially with long-term, large-dollar loans—like mortgages!—lowering the interest rate can result in serious savings in the long term.
- Lower monthly payments. If you refinance with a lower interest rate, your monthly payments will be lower. This gives you more cash to use for other things, like saving for retirement, building an emergency fund, or paying for everyday expenses.
- Shorten the loan term. Instead of restarting the loan clock like you would with a standard refinance, you can refinance into a shorter-term loan. For example, from a 30-year home loan to a 15-year home loan.
- Lock in low interest rates with a fixed-rate loan. If you have a variable- or adjustable-rate (ARM) mortgage, changing to a fixed-rate loan gives you protection against rising rates in the future.
Why refinancing isn’t always a wise move:
- Paying transaction costs. Refinancing closing costs, including processing and origination fees, can be thousands of dollars. Before you pay those costs, make sure you’ll earn it back in interest saved.
- Paying more interest. Refinancing restarts the clock on your mortgage, stretching it out to another 30 years (assuming you’re not refinancing to a short-term loan). When you stretch out loan payments over an extended period, you pay more interest on your debt overall. So while you might have lower monthly payments, that benefit could be lost by the higher lifetime cost of the loan. Doing a quick loan amortization will show you how your interest costs change with different interest rates and loan terms (i.e. repayment length).
- Having less flexibility. If you shorten the loan term, this can put you in a financial crunch if money gets tight. Instead of moving from a 30-year to a 15-year mortgage that will have higher monthly payments, simply make bigger payments each month on your current mortgage. This gives you the flexibility to pay as much extra as you can each month and doesn’t incur the closing costs of refinancing.
If you think refinancing is right for you
Here’s what you need to investigate:
- Associated costs
- Prepayment penalties on the new loan
- If you’ll need to add private mortgage insurance (PMI)
- If you’ll turn a nonrecourse loan into recourse debt by refinancing
- If your home equity will change
- A basic breakeven analysis. You need to know if and how much you’ll save over time, how long it will take to recoup any up-front costs, and if you’ll be in the home long enough to see these gains.