How Does Mortgage Refinancing Work?
A mortgage refinance replaces your original mortgage with a new one, ideally with a lower interest rate. You'll get a new interest rate and other loan terms, and you can make other changes to the loan, such as trading an adjustable-rate mortgage for a fixed-rate mortgage.
Mortgage refinancing makes sense when you can use it to save on interest, access home equity or both. Consider some reasons people refinance a mortgage:
- Pay
off your loan faster. If you shorten your loan term, such as
switching from a 30- to a 15-year mortgage, you will build equity and pay
off your loan faster.
- Save
on interest. Even
if you don't shorten your loan term, a lower interest rate could
save you money over the life of the loan.
- Reduce
your monthly payment by extending your loan term. Usually, a
mortgage with a longer term will have a lower monthly payment than a
mortgage with a shorter term. But the longer you take to pay off your loan,
the more interest you will pay overall.
- Convert
equity into cash. If
you have enough equity, you can take out some in cash and replace your
mortgage with a new one that may have new terms.
- Secure
a predictable payment. Switching from an adjustable-rate
mortgage to a fixed-rate loan locks in your interest rate, preferably
at a lower rate. Alternatively, you could switch to an ARM for savings in
the first few years of a mortgage if you know you won't live in your home
for long.
Reasons
to think twice before refinancing:
- You'll have to pay closing costs. Your potential interest rate savings may be offset by
closing costs when you refinance your mortgage.
- You may pay more over time. If you refinance into a new mortgage of the same term,
say a 30-year loan, you are essentially restarting the clock on your
debt.
- You're taking on more debt. With a cash-out mortgage refinance, you are
adding to your total debt balance to tap into your home's equity.
- You may be charged a prepayment penalty. Some mortgage lenders charge prepayment penalties to borrowers who
repay their loan before the term ends.
- Your payment could increase. If you refinance from a 30- to a 15-year loan, you will likely see your monthly payment jump.
What Are the Different Types of Mortgage Refinancing?
Here are some common
types of mortgage refinance loans:
- Rate-and-term
refinance. The
most common type of mortgage refinancing allows you to take the balance of
your original mortgage and borrow at a different rate, ideally a lower one,
and terms.
- Cash-out
refinance. This
option lets you take advantage of the equity in your home, replacing your
mortgage with a new, larger loan and giving you cash at closing.
- Cash-in
refinance. Borrowers
make a lump-sum payment at closing to build up home equity and qualify to
refinance for better mortgage rates and terms.
- Streamline
refinance. Qualified
homeowners with a mortgage through the Federal Housing Administration,
Department of Veterans Affairs or Department of Agriculture may be eligible
for more affordable terms if they refinance through these government
programs.
- No-closing-cost
refinance. Your
lender won't charge you closing costs upfront but will roll them into your
principal balance or raise your mortgage rate to cover the fees.
Credit score. Generally, home loan
refinance lenders require a minimum credit score of 620 for conventional loans.
But you could qualify for refinancing with special programs, such as
government-backed loans, if you have a lower credit score.
Debt-to-income ratio. You'll also need
sufficient income to qualify for your refinance. If your income has stayed the
same or increased while your home loan balance decreased, you should have no
problem with approval. Lenders generally won't approve a loan with a monthly
mortgage payment that's more than 28% of your total gross monthly income, but
there may be exceptions.
Loan-to-value ratio. LTV measures how much
you owe on your home loan compared with your home's market value. Typically,
mortgage refinancing companies look for at least 20% home equity and an LTV
ratio of up to 80%.
Expect to pay closing costs on a refinance similar to your original mortgage, generally about 2% to 5% of the loan amount. Charges may include lender fees, such as the origination fee, and third-party fees for inspection and appraisal.
On average, homeowners pay around $5,000 to refinance a mortgage, according to Freddie Mac. Before you refinance, use a mortgage refinance calculator to make sure your interest savings can offset your closing costs.
You could save money now and over time. One of the primary goals of refinancing is to lock in a lower mortgage rate. By doing so, you will typically be able to reduce your monthly mortgage payments and save money on interest charges over the life of the loan.- You
may pay off your mortgage faster. You may choose to shorten your
repayment term, such as refinancing a 30-year mortgage into a 15-year
mortgage. This helps you get out of debt faster and save a substantial
amount of money over time.
- You
can lock in a fixed interest rate. Refinancing from an adjustable-rate
mortgage to a fixed-rate mortgage eliminates the risk that your interest
rate – and monthly payments – will change at the end of your fixed period.
- You
can access your home's equity. A cash-out refinance allows you to
tap into your home's equity, which you can use to meet other financial
goals, such as renovating your house or paying off higher-interest debt.
- You
may be eligible to eliminate PMI. Once you've hit a loan-to-value
ratio of 80% or less, you may consider refinancing to get rid of private
mortgage insurance.
Select the best lender
to refinance your mortgage by evaluating product options, interest rates and
customer service ratings.
Product options: Look for a company
that offers the type of loan you want, whether that's a 15- or 30-year
fixed-rate mortgage; an FHA, VA or USDA loan; an adjustable-rate mortgage; or a
jumbo loan.
Mortgage refinance
rates: Once you find the right product, you can start shopping for the
right price. Prequalify with a few lenders to find out whether you meet the
minimum credit criteria and compare mortgage rates. Compare annual
percentage rates, which reflect interest and fees, for the true cost of
borrowing.
Customer service: Read reviews, ratings
and complaints to check that a company can offer good customer service. Check Better Business Bureau ratings
and search the Consumer Financial Protection Bureau's Consumer Complaint Database for common
grievances about lenders.
When you're ready to refinance
your mortgage, start by making sure you have a clear goal, whether it is
reducing your monthly payment or pulling out equity for home repairs. Next,
check your credit score to see whether it is in the ballpark to qualify for the
type of loan you want. The final steps are comparison shopping by getting
preapproved, gathering documents and applying, preparing for appraisal, and
getting your cash for closing if needed.
Mortgage recasting. A mortgage recast is when you put a large lump-sum payment toward your principal balance, which allows your lender to update your monthly payment for a fee.- Loan
modification. You may be able to extend your repayment term, reduce
your interest rate or switch from an ARM to a fixed-rate loan through your
current lender without going through the refinancing process.
- Home equity loan or line of credit. If you're looking to tap into your home's equity, you should also consider alternatives such as a HELOC or home equity loan.
0 Comments