What does it mean to refinance your mortgage?
When you refinance your mortgage, you replace the existing mortgage with a new one. This is usually done to reduce the monthly payment, interest rate, or a combination of both.
Perhaps the current mortgage is an adjustable rate mortgage (ARM), which when the loan was taken out, the payments were attractive due to the initial interest rate. Sometimes, an adjustable rate mortgage will have numbers in the terms like 5/25. This indicates the ARM will have a fixed rate for the first five years (possibly lower than normal), followed by an adjustable rate for the remaining 25 years.
At the end of the fixed rate term, the interest rate will adjust based on the bank index plus a margin set out in the terms of the mortgage. This could be higher than anticipated and make the monthly payments out of reach for a homeowner, resulting in the need to refinance.
What are the benefits of refinancing?
There are many advantages to refinancing a mortgage—here are some of them.
- You may be able to lower the monthly payments - If you manage to lower the monthly payments then the money saved can be put aside towards other purposes, or the savings could be applied to the new monthly payments to pay down the loan quicker.
- Private Mortgage Insurance can be eliminated - When the original conventional mortgage was taken out, and the down payment on the home was less than 20%, private mortgage insurance (PMI) would have been compulsory to protect the lender. If there is more than 20 percent equity in the home, or there has been enough principal paid off, if the mortgage is refinanced then the PMI may be eliminated, reducing the overall monthly payment.
- The length of the loan can be reduced - If the original loan was taken out when the homeowners were young, then a 30-year mortgage probably made the best financial sense. However, later in life, paying off the mortgage quicker might ease any financial burden and reducing the term of the loan would possibly solve that problem.
- Changing from an Adjustable Rate to a Fixed Rate mortgage - An adjustable rate mortgage is an attractive offer at the start, with the first few years interest fixed at a low rate, but when the initial period ends, the interest rate changes to adjustable and can go up or down. Refinancing with a fixed rate mortgage gives the homeowners some security knowing the payments will remain the same over the loan term.
- Accessing the cash built up in the equity - Over time, the value of the home might have increased and the loan balance will have been reduced with the monthly repayments. This results in more equity available to the homeowner to use a refinance mortgage to pay off things like high interest credit cards, other loans or even improvements to the home.
- Amalgamate a first mortgage and home equity loan - By combining the first mortgage, home equity line of credit, or home equity installment loan into one single mortgage with one monthly payment, makes life simpler and leaves the homeowner to concentrate on only one debt. Home equity loans and lines of credit invariably have adjustable interest rates, so refinancing with a fixed-rate mortgage can save money over time.
Are there risks in refinancing?
One risk that might transpire when refinancing a mortgage can be possible penalties from paying off the existing mortgage balance. Written into the mortgage agreement may be a clause stating what fees or penalties will be incurred if the loan is paid off within a certain time frame, and with some mortgages, these penalties can be thousands of dollars. Before refinancing, it is wise to check if there are any penalties, how much they will be, and if the new refinanced mortgage will cover them.
How do I refinance?
The refinancing process is practically the same as applying for a first mortgage. Homeowners need to get qualified for a refinance loan, in the same way as getting approval for the original mortgage.
Whatever the reason for considering to refinance the loan, checking with the current lender to see what options are available is a good first step. Also, shop around for lenders who have any special offers. Many mortgage companies allow online applications with only basic information submitted by the homeowners to give an initial quote. Ask whether any closing costs can be “rolled into” the new mortgage, so no actual cash is required at closing.
Like the original mortgage application, be prepared to submit all the documentation needed by the lender. Collect wage statements (generally three months’ worth), recent tax returns, bank statements, plus anything else that shows the state of your finances.
Since any lender will look at a potential borrower’s credit report, it might be prudent to take time to look at the report and try to find ways to boost the score. Keep payments up to date, lower credit card balances, but do not close any unused or zero balance cards, because closing an account may have an effect on the credit use ratio.
No matter what the reason is for refinancing a mortgage, make sure your finances are in order and they can substantiate the amount requested, and that the new monthly payment is well within reach.
