You can think of refinancing your mortgage as a debt redo. Essentially, you’ll swap out the existing loan for a new one – ideally with better terms and conditions.
Only this time it could help you save money on high mortgage payments, rather than just borrow it.
Here’s a breakdown on what it means to refinance your home.
Refinance Definition
A refinance is the replacement of current debt with a new debt obligation. This new loan will pay off the existing debt and reinstate a new loan agreement with different terms. You must have a certain amount of equity in the property before you can refinance.
The terms and conditions of the new loan will depend on personal finances, including your creditworthiness, inherent risk, and financial stability, as well as broader economic factors and trends.
If the borrower is under financial distress or has a cash flow problem, this may be referred to as debt restructuring rather than refinancing. The borrower can then renegotiate outstanding debt, the loan term, and hopefully restore liquidity.
Refinancing Your Home
You can refinance just about any kind of debt, including a mortgage loan. Often this will cut the interest rate, and therefore lower your monthly payments.
Does this sound too good to be true? Here’s the catch – refinancing isn’t free. Unfortunately, you’ll have to pay closing costs again. So, run the numbers and think about how long you plan to keep your home before opting to refinance.
Also, refinancing won’t reduce the original loan balance. In fact, you could actually take on more debt if you choose to roll the closing costs into the mortgage instead of paying them upfront.
Benefits of Refinancing
There are a few reasons homeowners look to refinance.
- Get a lower interest rate. Getting a better deal on a 15 or 30-year loan could really add up to a ton of savings.
- Shorten or extend the life of the loan. Shortening the mortgage schedule will lead to less interest paid over the loan term but will increase the monthly payments. Extending the timeline will do just the opposite – higher interest, lower payments.
- Covert an adjustable-rate mortgage (ARM) to a fixed-rate mortgage and lock in a lower interest rate. Fixed rates are beneficial for obvious reasons. They will stay the same for the entire loan term, no matter how the economy is doing.
- Consolidate and refinance multiple debts at once. This can simplify your payments if you have a number of outstanding dues, like credit card debt, student debt, an auto loan, etc.
The Different Types of Refinance Loans
There are three common types of refinance loans – rate-and-term, cash-out, and cash-in. Here’s a quick synopsis on each.
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Rate-and-Term Refinance Loan
This type of loan structure is used to change the interest rate, the loan term, or both. It will not make any changes to the amount on the loan principal or advance any cash to the homeowner.
The main goal is to secure a better interest rate or a more favorable loan term to lower the monthly mortgage payments and possibly pay it off faster.
Rate-and-term refinancing is often driven by a change in prevailing interest rates or a substantial improvement in the borrower’s credit that will allow them to refinance at a lower rate.
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Cash-Out Refinance Loan
A cash-out refinance is driven by the homeowner’s desire to tap into the home’s equity and cash out a portion of it – just as the name suggests.
This can be done in one of two ways. First, the home has been reappraised and the value has increased. Second, you can replace the current mortgage with a new loan at a higher amount than what you currently owe.
In both scenarios, the difference is received in cash. This capital can then be spent on home improvements, debt consolidation, or other delinquent stressors.
A cash-out refi can be a slippery slope. It makes sense if the interest rates are low and you have a valid, well-thought-out use for the money. But, if you’re refinancing to buy a brand-new car or pay down credit card debt only to rack it up again, this is not a good idea. The money should be used to put you in an improved financial standing.
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Cash-In Refinance Loan
A cash-in refinance loan is simply the opposite of a cash-out refinance loan. Instead of tapping into equity and taking cash out, the homeowner puts cash into the principal loan. Though far less common, there are a few reasons why a homeowner would put more into the loan.
If you want to refinance for a lower interest rate, but you’re having trouble getting loan approval, a cash-in refi can help to secure the funding. Additionally, it can eliminate private mortgage insurance (PMI) if you didn’t put 20% towards the down payment.
As an added bonus, a cash-in refinance will help pay off the loan principal faster and lower the amount of interest paid over the life of the loan.
This amortization schedule calculator can give you an exact estimate on how much you’ll end up saving and a projected timeline to pay off the loan.
Key Takeaways
- Refinancing your home involves taking out a new mortgage in place of the existing one.
- It makes sense if you want to lower your interest rate, shorten or extend the loan term, or get your debt under control.
- By refinancing, you could build more equity in the home faster and reduce your mortgage payments.
- It doesn’t come free. Closing costs will play a factor when refinancing.
- Remember – a savvy homeowner is always looking for new ways to reduce debt, save money, pay less in interest, and build equity. Consider all options to help achieve these goals, even refinancing.
