What is mortgage refinancing?

Own a home? Congratulations! Have a mortgage associated with that home? You’re not alone. As you may know, most mortgages are relatively long-term, lasting 15 or 30 years. A lot could change in that time frame, and the mortgage terms you initially agreed to may not work for you 10 years down the line.

That’s where mortgage refinancing comes in. It lets you change the terms or conditions of the loan, hopefully for the better. But what exactly is it, and when should you use it?

Mortgage refinancing: The basics

Simply put, mortgage refinancing refers to replacing your old mortgage loan with a new one.

There are many reasons to consider refinancing, but most people do it to reduce their interest rate or monthly payments.

Types of mortgage refinancing

Most lenders classify mortgage refinancing into one of three categories:

● Rate-and-term: This type of refinancing doesn’t involve changing your loan amount. Instead, you change the loan term and/or interest rate.

● Cash-out: With this refinancing, you get cash in exchange for increasing your loan amount.

● Cash-in: Here, you would add more money so that you can reduce your balance on the new mortgage.

Why do people refinance their mortgage?

Everyone has a different reason for wanting to refinance their mortgage. Still, some are more common than others.

For better interest rates and/or monthly payments

One of the most common reasons to refinance is to reduce your monthly payments or your overall mortgage interest rate.

This is an excellent option in two main situations:

● You’ve improved your credit score since your original loan and can now get better terms

● The market rates for interest dropped significantly since your original loan

To reduce the loan term

Every little detail of your loan affects its interest rate, including the length of the loan. In most cases, reducing the loan term lets you reduce your interest rate. Even if it doesn’t, shortening the loan term will save you money spent on interest.

To lengthen the loan term

If your monthly payments are currently too high and your mortgage is a shorter-term loan, then you may want to refinance to lengthen the term. This should result in lower monthly payments. Just remember that the longer the loan term, the more you will typically pay in interest over the life of the loan.

To change the type of interest rate

Lowering your interest rate is not the only change you may want when you refinance. You may also want to change the rate type. For example, you could switch from a fixed rate to an adjustable rate or vice versa.

To cash out

This type of refinancing appeals to homeowners who already have a lot of equity in the home, as refinancing would allow them to cash out some of the loan. That money could be used for other expenses, such as making a large purchase or paying bills.

"Simply put, mortgage refinancing refers to replacing your old mortgage loan with a new one."

To cash in

You may also want to refinance your mortgage if you want to add cash to it. Theoretically, you could do this if you had an unexpected windfall and wanted to dramatically lower your loan amount.

To take advantage of increased home value

If you get lucky and your home has increased in value since your original loan, refinancing can also make sense. This can frequently overlap with cashing out, as you can take advantage of the additional equity to get a similar loan.

To combine mortgages

Suppose you currently have two mortgages. In that case, you could refinance to combine them into one new loan.

Just remember that if you do have two mortgages, your new lender will have to do something called “subordinating” your second mortgage, so it is under your new first mortgage. This can take a bit of time and therefore requires extra planning.

Combining mortgages is common for people who:

● Want to keep a low mortgage amount

● Want a lower interest rate

● Want to change from private mortgage insurance

● Are underwater on their mortgage

So are there any cons associated with mortgage refinancing?

We already looked at some of the reasons that you may want to refinance your mortgage. But we should  look at both sides of the equation; refinancing has some disadvantages as well.

Potential downsides of refinancing:

● Savings are better earlier in the loan term: You can technically refinance your mortgage at any point in the loan term. That said, you will typically have more savings if you do so earlier in the loan term.

● No guarantees as to what you’ll find: You will start the refinancing process with a goal in mind, but there’s no guarantee that you’ll find the loan terms you want. Maybe you can’t find a loan with better terms and will waste your effort. Or perhaps you improved your credit score, but the market rates also rose, so you end up with the same interest rate. This is why it is so important to research your options before committing to a new loan.

● Potentially increase interest: As mentioned, if you lengthen your loan for lower monthly payments, you will end up paying more in interest over the entire loan period.

● Potentially raise monthly payments: If you decide to refinance the loan to shorten your loan term and save on overall interest, your monthly payments will increase.

● Potentially increase overall loan amount: The idea of cashing out part of your mortgage is appealing because it’s an easy way to get liquid funds. However, you end up with a larger loan balance in the end. That typically means higher monthly payments and/or a longer loan term.

● It can affect your credit score: Keep in mind that your credit score may drop a few points anytime you have a hard credit inquiry. You may also notice a reduction in your credit history when you refinance since the original loan will be closed.

When shouldn’t you refinance your mortgage?

Yes, there are a few situations when it isn’t the smartest decision to refinance:

You have a home equity loan

If you currently have a line of credit or home equity loan, it becomes more complicated to refinance because you would typically have to ask your lender for permission before refinancing. If they say no, you would have to pay off the loan before you could refinance, making it near-impossible in many situations.

You are moving soon

You want to think twice and pay attention to the math if you plan on moving soon. While it may still make sense to refinance your mortgage, do your math to ensure you break even or gain money.

You have a prepayment penalty

If your current mortgage has a prepayment penalty, you will need to factor that into your decision. Ask yourself whether refinancing would still be worth it even with the fee.

Some lenders will waive your prepayment penalty if you refinance, but this is something you should discuss before making a decision.

How to refinance your mortgage

If you decide to refinance your mortgage, you will notice that the process is similar to when you first got your home loan: you should compare the offerings from various lenders, looking carefully at the different interest rates and loan terms.

Some of the most important things to pay attention to include:

● Interest rate

● Length of loan or term

● Closing costs (cost of refinancing)

● Prepayment penalties

During the refinancing process, expect lenders to pay attention to similar factors as they would for your initial home loan. These include your:

● Credit score

● Credit history

● Income

● Employment history

● Other debt

Because the situation is slightly different from the initial mortgage, they will also consider your:

● Payment history for your current home loan

● Home equity

● Home’s value

The process of refinancing

Refinancing may sound complicated, but once you decide to go through with it, the process of breaking your mortgage contract is quite simple.

Plus, you don’t have to crunch the numbers yourself to figure out if refinancing makes sense for you. There are plenty of refinancing calculators online that can do the math for you. This makes it much easier to confirm that refinancing will save you money. Just take care of the following steps.

1. Find and apply for a loan that is worth the balance you owe to your current lender.

2. Get approval, and have your new lender pay off your old loan.

3. Now, you have the same balance but with a new lender and better monthly payments and/or interest rates.

Refinancing can offer you the opportunity to adjust your mortgage to fit your present needs. It can reduce your monthly payments or overall interest payments, freeing up disposable income to put to other uses or invest for the future.