Understanding Mortgage Refinancing – The Basics and Benefits
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The homebuying process begins with a mortgage, and for this, you need to consider your personal finance goals, budget, credit report, and monthly outgoings. Many homeowners use mortgages to buy their properties. Real estate investors also use these financial products since leverage allows investors to scale their portfolios and grow their cash flow.
At some point, you may want different rates and terms for your mortgage. A mortgage refinance makes this possible but will benefit some homeowners more than others. Knowing the different types of refinancing, as well as the pros and cons, can help you make a well-informed decision before approaching your lender.
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How does a mortgage refinance work?
A mortgage refinance allows you to swap your current mortgage loan for a new loan. The interest rate will definitely differ, but you can also end up with a different loan amount and duration. It all depends on how you structure the refinance.
Luckily, homeowners have many refinance options. They can use a refinance to minimize monthly payments, access extra capital, and accomplish other objectives.
During a refinance, you apply for another mortgage on your current property. If you get approved, the proceeds from the new mortgage immediately go toward the remaining balance on your current mortgage.
After a refinance, you are only making one monthly payment. Keeping your property debt under one monthly payment is simpler than taking out a home equity loan or a home equity line of credit (HELOC). You may incur a penalty cost for paying off your old mortgage early, and you’ll also have to contend with closing costs and other expenses when you get a refinance.
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Types of mortgage refinancing
Mortgage lenders give borrowers plenty of flexibility with refinances. Below are several options.
Rate-and-term refinancing
Rate-and-term refinancing is a common choice that allows you to get a new interest rate and loan duration. Homeowners often refinance their mortgages when interest rates drop. A lower mortgage rate reduces your monthly payments even if you keep everything else the same.
Some homeowners also adjust their terms to reduce their monthly loan payments. You will stay in debt longer if you turn a 15-year mortgage into a 20-year mortgage. However, switching will also spread your principal across 60 additional months. That equates to more reasonable monthly payments and can reduce financial stress for people in a pinch.
Cash-out refinancing
A cash-out refinance allows you to tap into your home equity without making two loan payments each month. For this refinance, you have to request a new mortgage that is greater than the balance on your current loan. You receive capital equal to the difference. For instance, if you have $300,000 left on your mortgage and want to borrow $200,000, you must initiate a cash-out refinance for a $500,000 mortgage.
Most homeowners who use cash-out refinances also extend their loans. Keeping the same term length can result in a meaningful increase in your monthly loan payments.
Mortgage lenders limit how much of your home equity you can access with a cash-out refinance or similar financial products. You typically need to keep your loan-to-value ratio below 80%. However, some lenders let you have an LTV ratio as high as 95%.
Cash-in refinancing
A cash-in refinance allows a homeowner to get out of debt sooner by pouring extra cash into their properties. This approach can also reduce your monthly payments since your mortgage’s balance will shrink.
A cash-in refinance is optimal for people who access an extra windfall through an inheritance, property sale, or other avenue. A homeowner with $300,000 can put that cash into a new mortgage and reduce their debt.
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If you've owned your home for 3+ years, you may be able to get cash out of your home and slash your monthly bills. It costs $0 to get connected with an expert and check your options. You'll be shocked to see how much you could save.
The benefits of a mortgage refinance
Mortgage refinances offer several advantages. You won’t get all of these perks with the same refinance, but receiving multiple perks with the same mortgage refinance is possible.
Reduce your monthly payments
Housing is the highest monthly expense for most people. It can take up a sizable amount of any monthly budget, and trimming your monthly mortgage payments can help your finances. Homeowners and real estate investors have two paths for reducing their monthly payments. The first option is to refinance at a lower interest rate. People who bought homes with high interest rates can wait for rates to decline before refinancing.
However, you don’t have to wait for interest rates to drop to score a lower monthly payment. You can add more years to the back of your loan and spread your principal payments across more periods. Turning a 10-year mortgage into a 15-year mortgage will reduce your monthly payments if the balance remains the same.
Get a new type of interest rate
A refinance lets you change your interest rate. It’s possible to get a lower interest rate if overall rates have dropped and your credit score has improved since you took out your existing loan.
While a lower rate is quite beneficial, refinances also give you the choice to change the type of interest rate you have on your home loan. Property owners can choose a fixed interest rate or a variable interest rate for their mortgages.
Fixed-rate mortgages have the same monthly payments, regardless of what happens to interest rates. On the other hand, adjustable-rate mortgages change based on the market rate. This model makes your monthly payments less predictable, but you can end up with lower monthly payments as rates decline. However, the reverse is also true. Your monthly payments on a variable-rate loan can increase if interest rates go up.
Some homeowners use variable-rate loans initially because the monthly payments are usually lower to account for the borrower’s risk. Borrowers who suddenly become nervous about a future rate hike or want to lock in a low rate can use a refinance to get a new type of mortgage rate. You can also refinance your mortgage and keep the same type of interest rate that you have. For instance, you can refinance into another fixed-rate mortgage if you have a fixed-rate loan.
Tap into your home equity
Homeowners build equity with every monthly mortgage payment they make. Equity also increases when a property gains value. While some homeowners want to become debt-free as soon as possible, others prefer to tap into their home equity. Real estate investors often use home equity from other properties to fund down payments for new acquisitions. This strategy allows real estate investors to build their portfolios faster, and it’s sustainable as long as properties generate positive cash flow.
A cash-out refinance makes this possible. Investors can access capital from their current holdings and extend the loan’s duration to increase their present cash flow.
Not everyone is a real estate investor, but you still may have to use a cash-out refinance for your primary home. This refinance can help with medical bills, vacations, and any other big-ticket expense.
Debt consolidation
Mortgages tend to have lower interest rates than most financial products. That’s because mortgages are secured loans that use your property as collateral. Property owners are more incentivized to keep up with monthly mortgage payments than personal loan payments.
Homeowners can use this dynamic to their advantage by using their home equity to consolidate debt. A cash-out refinance can give you the extra funds needed to cover your credit card debt and other higher interest-rate obligations. A refinance loan allows you to make manageable monthly payments and streamline every debt under one umbrella.
Debt consolidation centralizes debt and makes it easier to monitor. You can also borrow more home equity than you need so that you have a buffer to address monthly payments. However, it’s best to not borrow more than you need if your financial situation allows. That’s because a higher loan amount makes the loan more expensive to take out.
What to know before getting a mortgage refinance
While a mortgage refinance offers many advantages, it’s important to know the risks and some of the nuances associated with this financial product. These are the key details to keep in mind.
Your objective
Getting a new mortgage opens up many possibilities. You can get a lower interest rate, reduce your monthly payments, tap into more equity, or get out of debt sooner. You can’t achieve all of those objectives with the same loan, and some goals push you away from others. For instance, if you use a cash-out refinance, you will stay in debt longer, have higher monthly payments, or both.
Knowing what you want or need the most from your mortgage refinance can lead to a better outcome. It will also become easier to distinguish the best loan offers within the industry.
Your credit score
You will need a 620 FICO score or higher to refinance a conventional mortgage. An FHA loan has a more generous credit score requirement, but it’s good to see where you currently stand. A credit check and a higher credit score will grant you a lower interest rate and may increase how much you can borrow against your home equity. Building up your credit leading up to a refinance can help you save money. Payment history makes up 35% of your score, so stay up-to-date on all your bills.
Interest rates
Borrowers should pay careful attention to rates when they refinance. It’s common for homeowners to refinance their loans if they can get lower interest rates. However, that’s not always possible, and a refinance may be necessary to cover an urgent expense.
Reaching out to multiple mortgage lenders and comparing offers can help you get a lower rate. You can compare multiple loan options instead of rushing to do business with your current lender. If you end up with a higher total interest, and your goal is to reduce your monthly payments, you must extend the duration of your loan to achieve that goal. A shorter term on the loan will have higher monthly payments, while a longer term will have lower monthly payments.
Interest accumulation
Cash-out refinances typically involve adding more years to the backend of your loan to keep monthly payments the same while receiving extra capital. While you’ll get extra cash right now, the issue with extending your loan is that interest will accumulate.
If you stretch out your loan, you will owe more interest in the long run. Mortgage amortization schedules front-load your monthly payments with interest. It’s only when your mortgage gets to the halfway point that most of your monthly payment goes toward the principal.
Sometimes, refinancing is necessary. However, it’s not the best move for everyone, and it will keep you in debt longer.
Your financial situation
Some people take out home equity because of their financial situation. While some people need a cash-out refinance more than others, assessing how you got into this situation is important. While medical bills can surprise people and encourage them to take their health more seriously, racking up credit card debt is another matter. For some homeowners, a cash-out refinance can enable reckless spending.
Homeowners who want lower monthly payments should review their budgets and calculate the assistance they need. For instance, some people must shave off $150 from their monthly mortgage payments. Having a number can help you get the right term and rate for your refinance.
Closing costs
Closing costs equal roughly 2% to 6% of your new mortgage’s balance. If you take out a $500,000 mortgage for your refinance, you could look at closing costs ranging from $10,000 to $60,000. You can tack those costs to the back of your loan, but keeping them in mind is good.
American Homeowners Could Save Big With The Help Of U.S. Mortgage Experts
If you've owned your home for 3+ years, you may be able to get cash out of your home and slash your monthly bills. It costs $0 to get connected with an expert and check your options. You'll be shocked to see how much you could save.
The bottom line
A mortgage refinance allows you to achieve many objectives. You can get a new rate and loan terms, and it’s also possible to tap into the home equity you have built over the years. It’s best to compare offers from multiple lenders instead of immediately rushing to your current lender. Read the repayment terms and compare multiple rates and terms to get better financing. A refinance can ease financial stress, help with big expenses, and take you closer to your financial goals. However, it shouldn’t be used as an enabler that allows bad financial habits to go unchecked.
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Writer
Marc Guberti is a business freelance writer who specializes in personal finance, digital marketing, and entrepreneurship. His award-winning book "Content Marketing Secrets" teaches readers how to create, promote and optimize content for growth and revenue. Marc also hosts the "Breakthrough Success Podcast," where listeners learn how to master content marketing and get more clients.
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