With mortgage refinancing, you can rewrite the terms and replace your existing loan with one that benefits you even more. Refinancing your loan can give you the financial freedom to change your payments or reach financial goals.
Refinancing to a loan with a lower interest rate than your current mortgage can reduce your monthly payments or allow you to borrow against your equity. What is refinancing and how can you avoid the pitfalls of getting a new mortgage?
We’ll take a closer look at the ins and outs of refinancing a mortgage and the options that might work best for you.
What Does ‘Refinance’ Mean?
Refinancing a loan is when you replace an existing loan with a new loan. To refinance a loan, you pay off the existing loan with funds from the new loan. The new loan may come with better interest rates and shorter or longer repayment terms. You can also use it to draw on equity and get money to consolidate debt or make home improvements.
People often refinance a loan to take advantage of lower interest rates, reduce monthly payments, extend or shorten their loan term or switch from an adjustable-rate mortgage (ARM) to a fixed-rate loan (or vice versa). You can refinance with various types of loans, including mortgages, auto loans, student loans and personal loans.
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What’s The Goal Of Refinancing?
The primary goal of loan refinancing is usually to save money over the life of the loan. By securing a lower interest rate or extending the repayment period, borrowers reduce their monthly payments and could decrease the overall cost of borrowing.
Before you decide to refinance, consider whether the associated costs and fees will save you money in the long run. It’s a good idea to evaluate the terms and costs of the new loan carefully.
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What Does It Mean To Refinance A Home Loan?
Like refinancing other loans, refinancing a home loan means you replace your existing home loan with a new one. The mortgage refinancing process is similar to the original home loan process. That means your first step is to shop for lenders.
Keep in mind that you aren’t obligated to refinance with your current lender. You may decide to gather offers from numerous sources. Then, you can choose the refinance option that fits your situation best. Key financial indicators like your credit score, income and debt-to-income ratio (DTI) can affect the interest rates you qualify for.
When you find the right offer, you can replace your original loan with a new one. Your refinance lender will pay off the old loan, and you’ll start paying the new refinance loan instead. Ideally, this loan will have more favorable terms and lower your monthly payment.
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Equity Requirements For Refinancing
Generally, you’ll need at least 20% equity in your home to refinance. However, exceptions exist for homeowners with less than 20% equity. Let’s compare the two scenarios:
20% Home Equity Or More
A general rule for refinancing (or “refi”) is to have at least 20% equity in your home. Refinancing with this amount of equity allows you to eliminate private mortgage insurance (PMI), significantly lowering your monthly mortgage payment. Likewise, the 20% threshold is what you need to qualify for a cash-out refinance.
Under 20% Home Equity
If your equity is under 20% but you have a good credit rating, you may still be able to refinance. However, your lender may charge you a higher interest rate or require you to pay for mortgage insurance. Some loan types won’t have equity-based limitations and may allow for different types of adjustments. For example, interest-reduction Federal Housing Administration (FHA) refinance loans don’t have equity requirements.
Types Of Refinancing
Depending on why you’re refinancing you might have different financial concerns, goals and needs. Let’s take a look at the different types of loans and when you might want to consider them.
Rate-And-Term Refinance
A rate-and-term refinance is what most people think of when you talk about refinancing and is often used interchangeably with the term “refinancing.” It lets the homeowner change their loan’s mortgage rate, loan term or both while the loan balance is unchanged. This refi type can help you save money through a lower interest rate.
Additionally, you can extend the loan term, lowering your payments by spreading them out over a longer repayment period. If you refinance to a shorter loan term, your monthly payments will be higher because you’re paying off the same amount of money in less time. However, you save money in the long run by removing years of interest payments.
Cash-Out Refinance
A cash-out refinance converts your home’s equity into cash while refinancing your mortgage. You can use the money from a cash-out refinance for anything, including consolidating higher-interest debt. Cash-out refinancing is also excellent for borrowers with a lot of equity to use for home improvements.
A cash-out refinance replaces the borrower’s current mortgage, and the monthly payment amount is likely to be different under the new agreement. Because you’re withdrawing cash, your loan principal increases, meaning your monthly payment may increase.
Streamline Refinance
Streamline refinancing is similar to rate-and-term refinancing, but it’s specifically for government-backed loan programs like ones backed by the FHA, U.S. Department of Agriculture (USDA) and Department of Veterans Affairs (VA). Streamline refis offer simplified processes with reduced documentation requirements and underwriting standards. The three types of streamline refinance programs available are the FHA Streamline Refinance, VA IRRRL and USDA Streamline-Assist Refinance.
Each of these options can help you secure a lower interest rate and monthly mortgage payment. Certain Streamline refinance options also may not require a home appraisal or credit check.
Cash-In Refinance
If you’ve come into a lump sum of cash you didn’t have when you bought your home, a cash-in refinance lets you put the money into a new down payment. The refi can also get you a better interest rate and may let you eliminate your mortgage insurance premiums by building your equity and reducing your loan-to-value ratio.
No-Closing-Cost Refinance
A no-closing-cost refinance allows borrowers to conserve their funds by avoiding the upfront expenses of refinancing. By eliminating the upfront costs, they can use the saved funds for other purposes, such as paying off high-interest debt.
Despite how it sounds, a no-closing-cost refinance doesn’t mean that the borrower avoids paying closing costs altogether. Instead, the costs are incorporated into the loan balance or paid over time through a higher interest rate. That means this option can be advantageous for individuals who plan to refinance again or sell within a few years before the higher loan payments eat into their initial savings.
Short Refinance
A short refinance can help borrowers avoid foreclosure by implementing a new mortgage with a smaller balance. This way, monthly payments become more affordable and can help the borrower stay in their home.
Common Reasons For Refinancing
There are plenty of reasons that homeowners refinance their mortgages. While saving money is often a motivating factor, there are other reasons why people refinance their homes. Here are a few reasons to consider:
1. To Lower Your Monthly Payment
Some borrowers refinance their mortgages to secure a lower payment through a lower interest rate or longer loan term. Doing so can improve your monthly cash flow, lightening financial strain.
Improving your credit score once you become a homeowner can help you get a lower interest rate when refinancing, though market conditions will impact interest rates. In addition, you can remove private mortgage insurance (PMI) by refinancing once you have 20% equity in your home. Removing PMI lowers your monthly payment even if interest rates haven’t changed.
2. To Choose A New Loan Term
Refinancing allows borrowers to select a new loan term, such as switching from a 30-year mortgage to a 15-year mortgage. Shortening the loan term can help homeowners build equity faster and save on interest payments over time. Conversely, borrowers can opt for a longer loan term to extend payments and lower their monthly obligations.
3. To Get A Different Loan Type
Refinancing allows you to switch between loan types. For example, you can go from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage. With an ARM, the interest rate fluctuates over time, while a fixed-rate mortgage offers a stable rate for the entire loan term. This type of refinancing allows you to benefit from the ARM’s low initial interest rate and then change to a fixed-rate mortgage after a few years.
Pros And Cons Of Refinancing: At A Glance
There are both pros and cons to refinancing. Whether it’s a beneficial decision depends on your circumstances and goals. Let’s go over some of the most common advantages and disadvantages.
Pros And Cons Of Refinancing
| Pros | Cons |
|---|---|
| Refinancing can lock in a lower interest rate. | Refinancing requires paying closing costs on a new loan (3% – 6% of the loan amount). |
| Refinancing may mean a lower monthly payment. | Refinancing could shorten your loan term, resulting in a higher monthly payment. |
| Refinancing can lengthen or shorten a loan term, depending on borrower preference. | The new loan may take longer to pay off. |
| Refinancing can turn equity into cash, providing a needed financial bump. | A cash-out refinance creates a larger loan balance, possibly increasing monthly payments and lengthening the loan term. |
| Refinancing can eliminate an ARM and help maintain a low interest rate. |
How To Refinance Your Home Loan
Refinancing is a multistep process similar to taking out your original mortgage. Let’s take a look at the process step by step.
1. Check Your Credit Score
It’s essential to check your credit score and assess your creditworthiness. A higher credit score can improve your chances of qualifying for better loan terms and interest rates. If necessary, take steps to improve your credit score, such as paying down debts or resolving errors on your credit report.
2. Look At Your Home Equity
You can determine your home equity by comparing the current value of your home to the amount you owe on your existing mortgage. For example, if you owe $200,000 on a $350,000 home, you have $150,000 of equity. Lenders often require at least 20% equity to approve a refinance. Remember, having more equity can increase your chances of getting more favorable terms and options.
3. Shop Around For The Right Lender
Research and compare offers from multiple lenders, including banks, credit unions and online lenders, considering factors such as interest rates, fees, loan terms and customer reviews. In addition, examining specific policies, such as autopay and prepayment penalties, can help you choose the right lender.
4. Gather Required Documents
Prepare necessary documentation for a refinance, such as income verification (pay stubs, tax returns), bank statements and proof of assets. Lenders will also require information about your current mortgage, property and insurance. In addition, you can submit a letter of explanation to address a gap in your employment or a problematic item on your credit report.
5. Apply For Your New Loan
Once you choose a lender, the process of submitting a refinance application is similar to the mortgage loan process. You’ll provide accurate and complete information about your financial situation and your home. You may also need to pay an application fee.
6. Get A Home Appraisal
While your lender considers your application, they will arrange a home appraisal with a licensed appraiser to determine the home’s market value. This way, you’ll get an unbiased calculation to confirm how much equity you have.
7. Close On Your New Loan
Next, you’ll review your Closing Disclosure which outlines the details of your loan. This document contains the loan terms, including interest rate, closing costs and repayment schedule. If you agree to the terms, you’ll close on your refinance by attending a meeting where you sign the necessary paperwork. In addition, you’ll pay the closing costs, including origination fees, appraisal fees and title insurance.
What It Means To Refinance A Loan: FAQs
The answers to these frequently asked questions will help clarify whether a refinance suits you.
The Bottom Line
Refinancing can help you lower your interest rate, reduce monthly mortgage payments, access equity and change your loan type. However, there are potential drawbacks, including closing costs, a potentially larger balance and extending the loan term, which can nullify the benefits. Therefore, it’s vital to consider your goals and the associated costs and risks before deciding to refinance.
Ashley Kilroy
Ashley Kilroy is an experienced financial writer who writes for solo entrepreneurs as well as for Fortune 500 companies. She is a finance graduate of the University of Cincinnati. When Ashley isn’t helping people understand their finances, you may find her cage-diving with great whites or on safari in South Africa.
