What is refinancing?
In a nutshell, refinancing is getting a new mortgage to replace the original one. The bank or mortgage lender that grants you the new mortgage pays off your old one with a new mortgage, thus the term refinancing. Borrowers who choose to refinance do so to reduce monthly payments, lower interest rates, take cash out of their home for large purchases, or to change mortgage companies. Most people choose to refinance when they have accrued some equity in their home, which is the difference between the amount owed and value of the home.
Two main types of refinancing
Rate and Term Refinancing
A rate and term refinance is basically trading in your old mortgage(s) for a new one without raising the loan amount. In the example below, refinancing results in a shorter term with a lower interest rate so it will be paid of faster and with less interest. Two birds with one stone!
Original mortgage: $300,000 loan, 30-year fixed @6.25%
New mortgage: $300,000 loan, 15-year fixed @4.50%
In recent years, many homeowners have chosen rate and term refinancing to take advantage of historically low mortgage rates which can shorten the term without seeing major changes in their monthly payments.
Borrowers choose this type of financing to secure lower interest rates, change the term of the loan, switch from an adjustable rate mortgage to a fixed rate mortgage (or vice versa), go from an FHA to Conventional loan, or consolidate multiple loans into one. It is important that borrowers do the math while considering closing costs and other fees to make sure the numbers work in their favor for this type of refinancing to make sense for their situation.
Cash Out Refinancing
A cash-out refinance is exchanging your existing loan for a larger mortgage to get cold hard cash. In doing this, homeowners are tapping into their home equity.
Original mortgage: $300,000 loan, 30-year fixed @6.25%
New mortgage: $350,000 loan, 30-year fixed @4.75%
While cash out refinancing puts money in your pocket, you are left with a larger outstanding balance to pay back in addition to the closing cost from the new mortgage. It’s not free money. Also, depending on market rates, you may end up with a higher monthly mortgage payment. In the example above, the monthly payment goes down due to the substantial rate drop, and the homeowner gets the cash to do with as they please.
If you choose cash out refinancing, may sure the numbers work and you have a plan to pay back the loan. You don’t want to find yourself underwater or owing more on the mortgage than the property is worth.
If I decide to refinance…
Most banks and lenders require borrowers to maintain their original mortgage for at least 12 months before they are able to refinance. However, each lender and their terms are different, so check with the specific lender for all restrictions and details.
In many cases, it is easier and less expensive to refinance with your original lender, but it is not required. Since the lender knows both your payment history and the property, they most likely do not require a new title search, property appraisal, and other items normally required for a new loan. The lender may also be willing to offer a better price because it’s easier to keep a good customer than it is to find a new one. Ask your current provider what cost savings they offer to current customers who refinance with them.
With that being said, it is wise to find out what terms competing lenders offer. Saving a few hundred dollars in closing costs might not amount to much if you can get a lower interest rate from another lender. If you comparison shop by applying with several lenders, do it within a 30-day period. Your credit score won’t be hurt if you concentrate your applications within this time frame.
Speaking of your credit score… spend the time and money to review and correct any errors in your credit report to improve your score. Good credit allows you to get better mortgage rates. All three consumer reporting agencies can provide you with a credit score along with a credit report.
Reasons to refinance
A Lower Monthly Payment. It may make sense to pay a point or two to decrease your overall payment and interest rate if you plan on living in your home for the next several years. In the long run, the cost of a mortgage refinance will be paid for by the monthly savings gained. On the other hand, if a borrower is planning to move in the near future, they may not be in the home long enough to recover from a mortgage refinance and the costs associated with it. Therefore, it is important to calculate a break-even point, which will help determine whether or not the refinance would be a sensible option.
Go to a Fixed Rate Mortgage from an Adjustable Rate Mortgage. For borrowers who are willing to risk an upward market adjustment, Adjustable Rate Mortgages (ARM) can provide a lower monthly payment initially. They are generally a good option for those who do not plan to own their home for more than a few years. Borrowers who plan to make their home permanent may want to switch from an adjustable rate to a 30, 15, or 10-year fixed rate mortgage (FRM). While ARM interest rates may be lower, FRM borrowers will have peace of mind knowing exactly what their monthly payment will be for the duration of their loan. Switching to an FRM may be the most sensible option, given the threat of foreclosure, and rising interest costs. Many people choose to refinance because they are able to improve their credit score over time which may allow them to secure loans at lower interest rates than they could in in the past.
Avoid Balloon Payments. Balloon programs, like ARMs, are good for lowering initial monthly payments and rates. However, borrowers will have to pay the remaining balance in a lump sum at the end of the fixed rate term. Borrowers can refinance from a balloon program into a new fixed rate or adjustable rate mortgage.
Banish Private Mortgage Insurance (PMI). Low or zero down payment options can allow buyers to purchase a home with less than the conventional 20% down. Unfortunately, these mortgages usually require private mortgage insurance (PMI). PMI is designed to protect lenders from borrowers if they default on their loan. As the balance on a home decreases, and the value of the home itself increases, borrowers may be able to cancel their PMI with a mortgage refinance loan. Typically, the lender will decide when PMI can be eliminated.
Cash out a portion of the home’s equity. Generally, well maintained homes tend to increase in value over time. Homeowners are able to take out a home equity line of credit as the difference between the appraised value of their home increases and the balance owed on their mortgage decreases. Many people take equity out of their home to get money to cover large purchases like a new car, paying tuition, or a family vacation. Cash-out mortgage refinance transactions are not that difficult, and the interest should be tax deductible.
Cost of Refinancing
Application fee. This charge covers the cost of checking a borrower’s credit report, and the initial cost to process the loan request.
Title insurance and title search. This charge covers the cost of a policy (usually issued by the title insurance company), and insures the policy holder for a specific amount, covering any loss caused by discrepancies found in the property’s title. It also covers the cost to review public records to verify ownership of the property.
Lender’s attorney review fees. The company or lawyer who conducts the closing charges fees to the lender, which the lender will then charge to the borrower. Settlements are conducted by attorneys representing the buyer and seller, real estate brokers, escrow companies, title insurance companies and lending institutions. Usually, the person conducting the settlement is providing their services to the lender. Borrowers may be required to pay for other legal fees and services related to their loan, which is then provided to the lender. They may want to retain their own attorney for representation in the settlement, and all other stages of the transaction.
Points and fees incurred in loan origination. Lenders charge an origination fee for preparing and evaluating a mortgage loan. Points are prepaid financial fees which are imposed by the lender at closing. One point is equal to one percent of the actual loan amount.