What is Mortgage Refinancing?

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Point of Interest

Paying off debt and boosting your credit score could lead to a lower interest rate and reduced monthly payments when refinancing your mortgage.

Refinancing your mortgage provides many benefits, such as receiving a lower interest rate, reducing the amount of your current mortgage payment or taking out cash. With many homeowners experiencing financial hardship during the current pandemic, the ability to reduce their monthly mortgage expense or receiving much-needed cash to cover other expenses could be extremely beneficial. However, before embarking on any mortgage refinance, it’s imperative to research all your options to ensure refinancing is the right move for your financial situation. 

What is a mortgage refinance?

Simply put, refinancing your mortgage entails taking out a new loan for the remaining amount due on your home, which pays off and replaces your original mortgage. Homeowners refinance their mortgages for a number of reasons. These include receiving a lower interest rate, reducing the amount of their monthly mortgage payment by extending the loan length, or to convert the loan from an adjustable interest rate to a fixed rate. For those who can afford it, some homeowners refinance their mortgages for a shorter term, which results in a higher monthly mortgage payment but for a reduced amount of time. 

How refinancing works

Refinancing a mortgage is a very similar process to applying for a mortgage. You first should shop around for a lender that offers the best interest rates, loan terms and closing costs. The new rates, terms or other factors of the new loan should be a significant upgrade from what you have with your current mortgage for the pros to outweigh the cons. Once you select a lender, you will need to fill out loan applications, supply financial records, such as bank statements and paycheck stubs and undergo a credit check. Given thhat you previously qualified for a mortgage, this process may go a little more smoothly for a refinance, particularly if your financial situation has improved in the interim. 

Benefits of refinancing

Refinancing a mortgage can result in big savings for you in the form of a lower interest rate, a reduced monthly mortgage payment or shortening the term of your loan. Benefits of refinancing include:

  • Lower interest rate: Mortgage rates fluctuate often, so if you receive a lower rate by refinancing, you will save money in the form of reduced interest payments over the term of the loan. 
  • Reduced monthly payment: Refinancing your mortgage for a longer loan term means you will pay less for your monthly payment. 
  • Receive cash out: If you have a lot of equity in your home, you can borrow more than you owe on your current loan and take out extra cash to pay for expenses such as home improvements or purchasing a new car.
  • Shorten the loan term: If you can afford a higher monthly mortgage payment, you can refinance your mortgage to reduce the amount of time it takes to pay off your home. 

Closing costs

With every mortgage refinance, you are expected to pay closing costs on the loan. These closing costs cover such expenses as loan application and origination fees, real estate appraisal fees, home inspection costs, title search and insurance fees, document preparation fees and recording fees. Average closing costs range between 2% to 3% of the total loan amount. 

These closing costs vary from lender to lender, so it’s important to shop around to find the best terms for you. Also, it’s important to determine whether you will recoup these closing costs over the term of the loan. 

For instance, if you pay $6,000 in closing costs and your monthly mortgage payment drops $150, it would take 40 months to recoup the total closing costs. That’s not such a good deal if you aren’t planning to stay in the home for more than 3.5 years. 

Types of refinancing

All mortgage refinances are not the same. There are different types of refinances, each with its own individual terms and benefits. These include:

  • Rate-and-term: The goal is to reduce your interest rate, your loan term or both, with the same loan amount, in order to reduce your monthly payment. This also is a good opportunity to switch from an adjustable rate to a fixed rate. 
  • Cash-out: You can refinance to a loan that’s more than you owe on your current loan, taking out the extra amount in cash. However, you could pay a higher interest rate and monthly payment by doing this, so be careful.
  • Cash-in: This means you are paying cash to reduce your mortgage loan amount. 

Do I qualify for refinancing?

Qualifying for refinancing your mortgage is similar to qualifying for your original mortgage. The lender will examine your credit score and report, verify your current income and employment history, evaluate your home’s value, determine how much equity you have and review how much debt you owe beyond your home. 

If your financial situation is better than when you first applied for your mortgage, it’s likely the lender would offer you good or better terms compared to your original mortgage. However, if your debt has increased or your credit score has dropped, you may still receive an offer from a lender, but the terms may not be great. 

Tips on refinancing your mortgage

While refinancing your mortgage can offer some great benefits, choosing to refinance won’t always be the best option. Consider the following before embarking on a mortgage refinance:

  • Is the interest rate better? The general rule of thumb is to look for interest rates that are at least 2% lower than your current mortgage rate to justify the refinance costs. 
  • Will I recoup the closing costs? Do the math to make sure you will receive these costs back over the long term. 
  • Improve your finances for better terms. Reducing your debt and boosting your credit score can help you receive a lower interest rate. 

The final word

Refinancing your mortgage can be a smart financial move that results in big savings for you in the form of reduced payments, lower interest or even a shorter loan term. However, it’s important to carefully review the terms of any refinance offer to ensure you actually are paying less over the life of the mortgage. Otherwise, you might find yourself in a more costly loan than your original mortgage.