Essentially
refinancing a mortgage means paying off an existing loan and replacing
it with a new one. People seek to refinance their homes for many
different reasons. Here is a list of some of the most common reasons for a homeowners desire to refinance:
- Replace an adjustable-rate mortgage with a fixed-rate loan, or vice versa. Maybe the rate went too high on the adjustable or maybe the interest rates are dropping well below an owner’s fixed rate and they don’t want to miss out on the savings!
- Eliminate private mortgage insurance (PMI).
- Lower interest rate (most lenders would say that if the rate can be decreased by 1% them it may be worth the refinance).
- Shorten the term of a mortgage.
- Tap a home’s equity in order to finance a large purchase or have access to cash.
- Consolidate debt.
With
so many reasons to refinance, there are also different ways to
refinance depending on the situation. Below are the 2 most popular: - Cash-out refinancing:
- Taking out a new mortgage for more than what is owed. Someone would do this to have access to the difference in cash, potentially to pay off existing debt or some other reason.
- By doing this, the home owner is converting an unsecured debt into a secured debt, and the risk is that the bigger mortgage payments may be harder to keep up with and if missed, the home can be lost to foreclosure.
- Rate-and-
term refinancing: - Taking out a new loan for the remaining balance for a lower interest rate or a different term (number of years it will take to pay off the loan). Homeowners’ do this usually to save money if they plan on keeping the house for years to come.
- Someone can either choose a shorter-term loan with higher monthly payments so they can reduce overall interest payments and own their homes faster or stretch out the life of the loan to reduce the payments at a lower interest rate.
Now
that you know why people refinance, doesn’t mean that it is always a
good idea. So how do you know if refinancing is right for you? These are
our tips:
- Typically refinancing can cost 3%-6% of the loan’s principal. The process also requires application fees, appraisal, title search and other potential costs. This means that if someone is close to the end of their loan term, they might not want to refinance because of the costs incurred.
- If someone is attempting to lower their interest rate or obtain a shorter loan term, they must keep in mind that it takes years to recoup that cost with the savings generated by doing so. Many lenders can help owners calculate their breakeven point (time needed for refinance to “pay for itself” in savings) or use mortgage calculators to see if the process would be worth the savings.
- Another important thing to remember is that borrowers with a second mortgage will usually encounter added complexity with the refinancing process. With this situation, borrowers can choose between paying off the second loan or even combining the 2 loans into a larger first mortgage. If this does not happen, the mortgage holder of the second loan has to agree to stay in the second position behind the holder of the first loan.
- If you are trying to avoid paying PMI, a homeowner must have at least 20% equity in the property; otherwise the cost of the PMI may not be worth the refinance. However, some Fannie Mae and Freddie Mac programs and FHA loans may accept borrowers without the 20% equity. It is best to ask the lender to find out if the loan qualifies or not.
- Also, credit plays a role in determining if a borrower can secure a good mortgage rate. As with most things, the higher the credit score the better!
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