Refinancing your mortgage can save you thousands of dollars over the life of your loan, but it’s important to understand the ins and outs before diving in.
This comprehensive guide explores the different types of refinancing, when it makes sense to refinance, and how to choose the right loan structure to maximize your savings.
When it comes to homeownership, refinancing your mortgage can be a smart financial move. Refinancing can help you lower your monthly payments, reduce your interest rate, or change the duration of your loan. However, refinancing is not always the best option for everyone. In this comprehensive guide, we will explore the different types of refinancing, when it makes sense to refinance, and how to choose the right loan structure.
What is Refinancing?
Refinancing is the process of replacing an existing mortgage with a new one that has more favorable terms. This can include a lower interest rate, a shorter or longer loan term, or a change from a fixed-rate to an adjustable-rate mortgage. Refinancing can be done with the same lender or a different one.
The goal of refinancing is typically to obtain a lower interest rate, reduce monthly payments, or change the loan term. Even a small reduction in your interest rate can save you thousands of dollars over the life of your loan. Refinancing can also give you access to your home’s equity through a cash-out refinance.
Types of Refinancing
There are several types of refinancing, including:
Rate-and-Term Refinance
A rate-and-term refinance is used to change the interest rate or loan term of your mortgage. This type of refinance can help you:
- Lower your interest rate to reduce your monthly payments
- Shorten your loan term to pay off your mortgage faster
- Lengthen your loan term to lower your monthly payments
With a rate-and-term refinance, the original principal balance remains the same. You cannot take cash out with this type of refinance.
Cash-Out Refinance
A cash-out refinance allows you to borrow against the equity in your home and receive cash at closing. To qualify for a cash-out refinance, you need to have built up at least 20% equity in your home.
Reasons for a cash-out refinance include:
- Paying off high-interest debt like credit cards
- Funding home improvement projects
- Paying college tuition
- Making a large purchase
- Having cash reserves
The benefits of a cash-out refinance include consolidating other debts under one low mortgage interest rate and accessing your home equity without having to sell. The risks include possible over-leveraging and larger monthly mortgage payments.
Streamline Refinance
A streamline refinance is available for homeowners who already have an FHA, VA, or USDA loan. This type of refinancing has a simplified application process that typically doesn’t require:
- An appraisal
- Income verification
- Credit check
To qualify for a streamline refinance, you need to have made your mortgage payments on time over the prior 6-12 months. This type of refinance allows you to obtain a lower interest rate with minimal documentation.
No-Closing Cost Refinance
Some lenders offer no-closing cost refinancing, which rolls the closing costs into the loan amount. This avoids upfront costs but increases the total interest paid over the life of the loan. No-closing cost refinancing can make sense if you plan to stay in the home long enough to break even.
Cash-In Refinance
A cash-in refinance allows you to bring cash to the closing table to lower your principal balance. This can help you build equity faster by immediately lowering the amount you owe on your home. To obtain a cash-in refinance, you’ll need funds available to put down at closing.
When to Refinance
Refinancing can be a smart financial move in certain situations, such as:
Interest Rates Have Dropped
If interest rates have dropped at least 0.5-1% since you obtained your original mortgage, refinancing could potentially save you hundreds of dollars per month. Use a refinance calculator to estimate your potential savings. The rule of thumb is you should be able to recoup closing costs within 18 months for refinancing to make sense.
Improved Credit Score
If your credit score has improved significantly since you took out your original mortgage, you may now qualify for a lower interest rate. An increase of at least 50 points may lead to a lower rate.
Want to Change Loan Terms
Refinancing gives homeowners flexibility. You can refinance into a shorter loan term to build equity and pay off your mortgage faster. Or you can lengthen your term to lower monthly payments. Refinancing also allows you to switch from a fixed to an adjustable-rate mortgage, or vice versa, to take advantage of lower rates.
Tapping Home Equity
A cash-out refinance allows homeowners to access their equity, converting it to cash. Home equity is often considered cheaper than other financing options. The money received can be used to fund home improvements, pay off higher interest debt, or make other large purchases.
Moving Soon
If you plan to move within the next 1-3 years, refinancing to a lower rate with a shorter term can reduce interest paid over the remainder of your time in the home.
How to Choose the Right Loan Structure
Choosing the right loan structure is important when refinancing your mortgage. Here are key factors to consider:
Interest Rate Type
Fixed rate: The interest rate remains the same over the full loan term. Offers predictability of monthly payments.
Adjustable rate (ARM): The initial interest rate is fixed for a set period, after which it adjusts periodically based on market conditions. May have lower initial rate but more long-term risk.
Fixed rates are preferable when interest rates are low and unlikely to drop further. ARMs can offer lower initial payments but require accepting future rate volatility.
Loan Term Length
Shorter term: 15 or 20 years. Builds equity faster and pays off mortgage sooner but higher monthly payments.
Longer term: Up to 30 years. Lower monthly payments but pay more interest over loan life.
Choose based on monthly budget, how long you plan to stay in the home, and total interest savings.
Closing Costs
Closing costs for refinancing average 3-6% of the loan amount. These represent upfront fees for loan processing, origination, appraisal, taxes, title insurance and more.
No closing cost mortgages roll costs into loan amount rather than paying upfront. This increases total interest paid over loan life.
Lender credits apply towards closing costs. Often require taking a slightly higher rate.
Compare options to balance upfront costs with overall interest savings. Shop around with multiple lenders.
Break-Even Horizon
Calculate when you will recoup closing costs through lower monthly payments. Generally 12-18 months is ideal to make refinancing worth it.
If you don’t plan on staying in the home long enough to break even, refinancing may not be cost-effective.
Refinancing Process Overview
Once you’ve decided refinancing could benefit you, here is a general overview of the process:
- Research current interest rates and lenders
- Check your credit score and report for any issues
- Determine your goals for refinancing
- Collect documents needed for application
- Complete loan application with lender
- Home appraisal if applicable
- Underwriting review of application
- Receive loan estimate from lender
- Final loan approval
- Scheduling closing date
- Sign final loan documents at closing
- Old mortgage is paid off with funds from new loan
The refinancing process typically takes 30-60 days from application to closing. Rate locks last 60-90 days to give time to close after applying. Having all your documentation ready can help speed up the process.
Tips for Refinancing Success
Follow these tips to ensure you get the best refinance for your situation:
- Shop around with multiple lenders for rate and fee quotes
- Get pre-qualified to see potential terms and rates
- Compare total costs, not just interest rates
- Prioritize lenders that provide full transparency
- Ask about lender credits to offset closing costs
- Review rate lock policies and duration
- Check if you can lower your rate further with points
- Avoid cash-out refinancing more than 80% of your home equity
- Refinance only if you will break even within 18 months
- Understand the costs of a float-down option for rates
- Check for first-time homebuyer refi programs if applicable
- Time application for best rate if possible (often late fall)
Alternatives to Refinancing
If refinancing is not the right option for you currently
- Mortgage recast: Also known as re-amortization, this recalculates your remaining mortgage payments to be lower after making a lump sum payment. No new loan or closing costs.
- Home equity loan or line of credit: Can access your equity with a fixed-rate second lien or revolving line of credit. Typically higher rates than refinancing.
- Loan modification: Your lender may allow modifying your existing mortgage terms, such as extending the repayment period. Limited options compared to a refinance.
- Pay extra principal: Making additional principal payments reduces your loan balance faster. Easy to do but doesn’t change your underlying rate/terms.
- Wait for lower rates: If you just refinanced recently, it may make sense to wait for another drop in rates down the road before refinancing again.
- Improve budgeting: If your goal is to lower monthly payments, look for areas to reduce spending and pay down debts faster.
- Sell the property: If you want to tap equity or no longer wish to be tied to the property, selling and downsizing is an option.
- Renegotiate with lender: In certain hardship situations, your lender may be willing to negotiate reduced payments.
The best approach depends on your specific circumstances and financial situation. Consulting with a loan officer or financial advisor can help identify the most strategic options beyond refinancing.
Conclusion
Refinancing your mortgage can lead to substantial interest savings and better loan terms if done strategically. But it’s not a universally good option for all homeowners. Carefully assess your goals, timing, costs and alternatives before moving forward. This guide covers key considerations around different refinancing types, ideal situations for refinancing, choosing the right loan structure, and overviews the process. Do your due diligence with mortgage rate shopping and cost comparisons. Seek professional advice as needed. With the right approach, refinancing can unlock savings and flexibility with your most important financial asset – your home.
