Refinancing Explained
A homeowner refinances when they obtain a new mortgage loan to replace their present one. The new loan should assist them in saving money or achieving another financial objective.
For instance, most individuals refinance to cut their interest rates and monthly mortgage payments, saving thousands of dollars in mortgage interest. However, you can also refinance into a different loan type, decrease your loan term to pay off the property faster, or withdraw home equity.
As a result of rising house values, many homeowners have increased equity and are eligible for refinancing.
Refinancing a Mortgage?Â
Refinancing includes replacing a current mortgage loan with a new one.
When refinancing, you apply for a new mortgage loan, just like when you initially purchased your property. But this time, the loan is utilized instead of purchasing a property to pay down your existing mortgage debt.
Refinancing effectively replaces the existing mortgage debt. Additionally, it allows you to pick the interest rate and loan duration for your new mortgage. It will enable you to obtain a new home loan that saves money or helps you achieve other financial objectives.
How Is Refinancing Done?
Unless you undertake a cash-out refinance, you do not receive the loan monies when you refinance. Instead, the transaction will be handled by the lender(s) concerned. After closing, you will begin making monthly payments on the new loan, which your refinancing lender will use to pay down your previous mortgage.
From your perspective, the mortgage refinance procedure often resembles the initial home loan process. Although refinancing typically results in lower closing costs, this is only sometimes the case.
Homeowners refinance because they can select the new mortgage’s interest rate and loan terms. So you may obtain a new loan that is more reasonable or assists you in achieving other financial objectives (more on that below).
Example of Home Loan Refinancing
The most prevalent motivation for refinancing is to obtain a cheaper interest rate. Typically, this decreases your monthly mortgage payments and your long-term interest expense.
Suppose you purchased a home two years ago. The home’s price was $300,000. You paid a $30,000 down payment and obtained a $270,000 mortgage to cover the remaining purchase price.
Now that interest rates have declined, you wish to lock in a lower mortgage rate to cut your monthly payments. So you decide to refinance.
- Your loan debt with Lender A is currently $260,000
- You discover that Lender B can provide you with a cheaper interest rate than your present lender.
- You apply for a mortgage with Lender B, requesting a $260,000 loan sum.
- You have been authorized for the refinancing loan.
- Lender B applies the $260,000 to your obligation owed to Lender A.
- Now you make mortgage payments weekly to Lender B
- You still owe $260,000, but you now have a reduced interest rate and more affordable monthly payments.
You are not required to continue working with your current mortgage lender or loan servicer.
If the lender you used to purchase your property can give you a lower interest rate and better conditions, you may refinance with that lender. However, you are also free to shop for a provider that offers a better value.
It is strongly suggested that you do so. Since you obtained your first mortgage, your finances have undoubtedly changed, and your initial lender may be no longer your best option.
The Advantages of Mortgage Refinancing for Homeowners
Your finances will inevitably evolve. You will create equity in your house, your income may rise, and you may pay off your credit card obligations and enhance your credit reports.
As your financial situation improves, you will likely have greater mortgage alternatives than when you initially purchased your property. Among the advantages of mortgage refinancing are the following:
- One can save money by borrowing at a cheaper interest rate. Mortgage interest rates fluctuate regularly. Even if your financial situation hasn’t changed, you may refinance to a lower rate and save money if rates have declined since you took out your mortgage.
- Refinancing your mortgage involves modifying its terms. You may pick the length of your loan (the “loan term”), the type of your interest rate (fixed or variable), and even the mortgage closing charges you incur.
- Quicker house ownership, elimination of mortgage insurance, and cash out. Numerous homeowners refinance to obtain a cheaper interest rate. But mortgage refinancing can help you pay off your house faster, remove mortgage insurance, or access your property’s value to pay off debt or finance home upgrades.
- A mortgage interest deduction may be advantageous for a subset of borrowers. Generally, mortgage interest is tax-deductible; thus, if you can consolidate other debts into your mortgage, you may be able to deduct the interest on those debts. However, you should always consult a tax expert before making any tax-related decisions.
Even in rising interest rates, there are valid reasons to refinance. For instance, withdrawing home equity is an excellent approach to fund home upgrades and other major costs. Alternatively, you might refinance from an FHA loan to a conventional loan to eliminate mortgage insurance.
Regardless of your motivation for refinancing, you should shop around for the best terms on your new mortgage.
Three Types of Mortgage Refinance
There are three kinds of mortgage refinancing. The ideal refinance loan choice for you will depend on your financial situation.
- Refinance of the interest rate and repayment period
- Cash-out refinance
- Cash-in-refinance (a variation of a rate-and-term refinance)
The rates for refinancing differ amongst the three loan categories.
Term-and-Rate Refinance
A rate-and-term refinancing allows homeowners to modify their current mortgage’s interest rate, loan term, or both. The mortgage term is the duration of the loan.
As an illustration, a homeowner may refinance:
- From a 30-year mortgage with a fixed rate to a 15-year mortgage with a fixed rate
- From a high-interest 30-year fixed-rate mortgage to a new 30-year mortgage with a cheaper fixed rate
- From a 30-year fixed loan with a high rate to a 15-year fixed loan with a reduced rate
A rate-and-term refinancing loan is intended to save money. You can save money month-to-month with a lower monthly payment or pay less interest with a shorter loan term and a lower mortgage rate.
Your monthly payments will increase when you refinance into a loan with a shorter term. This is because you are paying off the same amount of money in less time. However, you save more money over time because you eliminate years of interest payments.
Most refinances are rate-and-term, especially when mortgage rates are decreasing.
Cash-out Refinancing
The purpose of cash-out refinancing is to convert home equity into cash.
Home equity refers to the percentage of a home that you own. For example, if you owe $200,000 on your mortgage and your property is worth $300,000, you have $100,000 in home equity.
However, stock is not liquid cash. You must take out a loan against your home’s worth to access it. This is where refinancing with cash-out comes in.
Remember that with a rate-and-term refinance, your new loan total is equal to what you owe on the property and is used to pay down your previous mortgage.
The distinction with cash-out refinancing is that your new loan sum is more than your existing debt. The new loan is used to pay down your old mortgage balance, and the “remaining” funds are what you’re cashing out.
Cash-out Refinancing Example
Here’s a straightforward illustration of how cash-out refinancing works:
- Home value: $300,000
- Current outstanding loan balance: $150,000
- New balance owed: $200,000
- $50,000 in cash received at closing (minus closing costs)
Since the homeowner owes the bank only the initial amount, the “additional” sum is paid in cash at closing. Or, in the instance of a debt consolidation refinancing, the money is distributed to creditors, including credit card companies and student loan administrators.
When the second mortgage was not taken out at the time of purchase, cash-out mortgages may also be utilized to consolidate the first and second mortgages.
In a cash-out refinance, the new loan may have a lower interest rate or a shorter duration than the old loan. However, the primary objective is to earn liquid cash; therefore, a lower interest rate is unnecessary.
Cash-out Requirements
The approval conditions for cash-out mortgages are more severe than those for rate-and-term refinancing mortgages because cash-out mortgages pose a greater risk to the lender.
For instance, a cash-out refinance may be restricted to a smaller loan amount than a rate-and-term refinance or demand better credit ratings at the time of application.
Most refinancing loan programs also require borrowers to retain 15 to 20 percent of their home’s equity. That implies you will only be able to extract a fraction of your home equity.
Cash-in Refinancing
The opposite of a cash-out refinance is a cash-in refinance.
With a cash-in refinance, the homeowner brings cash to closing to pay down their loan debt and reduce the amount owed to the bank. This may lead to a cheaper interest rate, a shorter loan period, or both.
There are several reasons why homeowners choose for cash-in mortgage refinancing.
- To get cheaper rates of interest, which are only accessible at lower loan-to-value ratios (LTVs). LTV quantifies the loan amount relative to the home’s value. For example, a loan with an LTV of 80% will typically have higher interest rates than a loan with an LTV of 75%.
- To discontinue mortgage insurance premiums. When your conventional loan’s LTV falls below 80%, your private mortgage insurance (PMI) premiums are no longer payable.
This restriction does not apply to FHA loans, which demand mortgage insurance premiums (MIP) for the duration of the loan.
A homeowner might swap an existing FHA loan with a conventional loan through the refinancing procedure. This method might reduce mortgage insurance premiums (MIP) and increase your monthly savings.
The Process of Mortgage Refinancing
When you refinance a mortgage, you generate a new loan with new conditions. This normally necessitates a comprehensive mortgage application and approval procedure.
The underwriters of mortgages will analyze your application in three distinct areas:
- Credit rating and credit record
- earnings and employment background
- Assets and cash on hand
Here is a comprehensive list of refinancing criteria.
In addition, your house will be assessed to validate its current market worth, exactly as it was when you obtained your present mortgage.
How Does the Refinancing Process Vary From Purchasing a Home?
Despite the similarities between refinancing and purchasing, refinancing often requires less documentation from the borrower.
You will still be required to present W-2s, tax returns, and pay stubs as proof of income, bank statements as proof of assets, and documentation of citizenship or U.S. residence status. However, you will not be required to supply information on the initial transfer of the residence.
Additionally, since there is no pressure to finish a refinancing — unlike a house purchase — you have more time to comparison shop and locate the lowest interest rate. Since the primary objective of refinancing is to save money, you should compare lenders to obtain the cheapest refinance rate and costs.
How Long Does Refinancing Take?
Frequently, refinance mortgages may close in 30 days or less. However, consider that closing times might be affected by market conditions. If rates have dropped significantly and many homeowners are rushing to refinance simultaneously, closing might take 40-45 days or more.
Low-document Refinancing
Typically, refinance lenders must examine your income, assets, and credit history. However, several refinancing programs allow you to circumvent this verification procedure.
These are Streamline Refinances programs. They are “streamlined” because underwriting standards have been streamlined and optimized for speed.
With Streamline Refinancing, mortgage lenders forgo substantial portions of their “normal” mortgage refinance approval procedure. Frequently, house evaluations, income verification, and credit score checks are waived.
Streamline Refinance loans are available to homeowners whose current mortgage is guaranteed by the federal government, including FHA, VA, and USDA loans.
Although different lenders may establish their standards (which may include appraisals and credit approval), the following are the basic principles for Streamline Refinancing.
FHA Streamline Refinance
The FHA Streamline Refinance is offered to homeowners with an FHA loan. This refinancing product does not need a credit check, income verification, or house appraisal.
In general, FHA refinancing rates are modest. As with an FHA home purchase loan, homeowners must pay upfront mortgage insurance and yearly mortgage insurance fees (MIP). These additional expenses will affect your refinancing savings.
To qualify for the FHA Streamline program, on-time mortgage payments are required. And a “net tangible advantage” is necessary, which means that the refinancing mortgage must have a considerably lower interest rate and monthly payment than your existing loan.
Refinancing with cash-out is not permitted under the FHA Streamline Refinance program. FHA does provide a cash-out refinancing loan, but it requires a comprehensive application process and often higher credit score criteria.
VA Streamline Refinance (IRRRL)
The VA Streamline Refinance is offered to existing VA-backed mortgage holders.
The VA Streamline Refinance, commonly known as the VA Interest Rate Reduction Refinance Loan (IRRRL), waives income, asset, and credit score verifications.
Refinancing Except for homeowners switching to a shorter loan term, such as from a 30-year loan to a 15-year loan; or from an adjustable-rate mortgage to a fixed-rate mortgage, VA homeowners must demonstrate that the refinancing mortgage would result in monthly payment savings.
Cash-out refinancing is not permitted with a VA Streamline Refinance.
USDA Streamline Refinancing
Existing USDA mortgage holders are eligible for the Streamline Refinance Program. USDA loans, geared for rural or suburban homes, permit up to 100 percent funding.
The Streamline Refinance Program of the United States Department of Agriculture does not usually examine income, assets, or credit. And homeowners refinancing under the program are restricted to 30-year fixed-rate mortgages; ARMs are not permitted.
Cash-out refinancing is not permitted through the USDA Streamline Refinance.
