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How to Refinance Your Mortgage
Refinancing your mortgage may help you cash in on interest rate savings, lower monthly payments and even get you access to your home’s equity. Before you move forward with a refi, though, you need to know what situations a refinance is ideal for.
Mortgage interest rates are extremely low right now, so the talk of the town among homeowners is refinancing. While homeowners are right that refinancing brings a lot of benefits to the table, it also opens the door for questions, too. Knowing when to refinance your mortgage and how to refinance your mortgage is a critical part of cashing in on benefits like lower payments, more favorable repayment terms and interest savings.
What is a mortgage refinance?
Mortgage refinancing is the blanket term that refers to taking out a new home loan to pay off your existing home loan. Once completed, you’re no longer bound by the terms of your original home loan. You get new terms and new rates with your new loan instead. This is often done to capitalize on a better interest rate or to lower the size of your monthly mortgage payments.
While traditional refinancing is fairly straightforward, there are other types of mortgage refinancing available, too. For example, a cash-out refinance allows you to tap into the equity you’ve built in your home in the form of a cash loan that can be used for large purchases or debt consolidation. You’re still paying off your old loan and replacing it with a new loan, but you’re getting a lump sum of cash in the process. The new loan amount will be higher than the old one, though, because you’ll have to pay back the equity you borrowed during the refi.
But what do you do if you don’t have a conventional loan? You may still be able to refinance, even if you opted for a more specialized loan type when you bought your home. For example, FHA loans can be refinanced through the FHA Streamline program. With this program, you can capitalize on the same benefits, but it requires less credit documentation, no appraisal and minimal underwriting. In other words, the process is much easier and faster than a traditional refinance.
No matter what type of mortgage refinance you’re doing, the bottom line is the same. You’re taking out a new loan to pay off your existing mortgage to take advantage of more favorable loan terms. What those terms are is up to your unique situation.
[Read: Tips for Getting a Mortgage]
Why a lower interest on a mortgage might be rewarding
One of the chief reasons to refinance your mortgage is to save with a lower interest rate. While you won’t realize the savings immediately, over time you’ll begin to capitalize on the lower cost of borrowing.
For example, let’s say that you have a $300,000 outstanding loan balance with a 5.5% annual interest rate and 25 years (300 months) left on your loan. Your current monthly payment is $1,842. If you have the option to refinance to a rate of 3.5%, you could save significantly. By refinancing to a new $300,000 loan with a 3.5% APR and 30 years (360 months), your payments would drop to $1,347 a month.
The savings would be about $495 a month. If you didn’t refinance, you’d pay $552,600 over the remainder of your loan. When you refinance with this example, you are adding five years onto your payments, but the total you’ll pay is still considerably less at $484,920.
The reason you won’t realize these savings immediately is because of closing costs. For example, if you had to pay $6,000 in closing costs on this deal, you be down $6,000 in the first month and only recouping $495 in savings.
However, as time goes on, the savings would chip away at the closing costs. When you hit the breakeven point, the savings would cover the closing costs and you’d start to reap the benefits of your refinance.
Benefits of a refinance
There are several good reasons to refinance your mortgage.
- Pay off your mortgage sooner: By refinancing your mortgage from a 30-year mortgage to a shorter-term mortgage–20-year or 15-year–means you can pay off your mortgage much sooner.
- Change loan terms: If you switch from a 15-year mortgage to a 30-year mortgage, your monthly payments may be lower because they are stretched out over an extended period of time.
- Lower your rate: Refinancing your original loan can lower your interest rate, which can also lower your monthly payments.
- Remove PMI: If you have 20% equity in your home, you can rid yourself of mortgage insurance by refinancing.
- Change rate types: If you have an adjustable rate mortgage, you may want to take advantage of low interest rates and switch to a fixed mortgage.
- Borrow against your equity: You can also cash in on your home’s equity and pay for home improvements or other expenses.
Drawbacks of a refinance
Refinancing your mortgage has several benefits and also a few disadvantages.
- Additional closing costs: You will pay closing costs when you refinance your loan– about $5,000 on average – which are similar to the ones you paid when you first acquired your first mortgage.
- No-closing-cost refis could cost you more: You may not pay upfront closing costs if your lender wraps them into your loan, but that ends up costing you more over the long haul in most cases.
- The break-even point can take years to reach: You’ll also want to calculate your “break-even” point, which is when you’ll break even after refinancing after the costs. For example, if you save $100 each month by refinancing your mortgage, it will take a total of 50 months, or just over four years, to break even.
- You could end up paying more in interest: If you aren’t careful, you could end up paying more in interest on the new loan — especially if you’re extending the loan term by refinancing. When you refinance, you start the amortization period all over again, which adds more total interest to the loan.
Am I eligible for refinancing?
A question by those wondering how to refinance your mortgage is whether or not they’re eligible. The best way to answer this question is by better understanding the refi process. When you’re refinancing, you are going through what is effectively the same process you went through when you purchased your home. You will have to deal with a loan closing, closing costs and many of the same steps that came with the first loan.
What this means is that eligibility requirements will be relatively the same. The new lender will look at your credit history, credit score and your debt-to-income ratio. The lender may also look at the value of your home. If the value has decreased significantly you may owe more than the house is worth, which is something that could cause your refinance loan to be denied.
When preparing to refinance, you’ll first need to gather all of the same documents you needed when you purchased your home. You’ll also need to collect all of the documents from your first loan as well as proof of your on-time payments. The new lender will need to see all of this to assess the situation and determine your eligibility for refinancing.
Should I refinance?
Determining whether you should refinance and when to refinance your mortgage can seem confusing. Luckily, it boils down to one thing — can you get a better rate, more favorable repayment terms and save money by refinancing? If you can, then you should consider a refinance.
There are a few other things to consider as well, though. Do you have the money to cover closing costs? Are you staying in your home long enough to realize the savings?
- If interest rates are lower or your financial situation has improved (better credit score), you should look into refinancing.
- If your home has decreased in value significantly, you shouldn’t look into refinancing.
- If you aren’t staying in your home long enough to realize the financial benefits, you shouldn’t refinance.
- If you need access to cash for a fiscally responsible purpose and have a lot of equity built up in your home, you may want to consider refinancing.
Ultimately, if you have the financial resources to make a refinance happen and you can save money by doing it, it’s a move worth considering. A good lender can always help you weigh the pros and cons of your unique situation before you move forward.