What Is Refinancing?

What Is Refinancing?

Refinancing is essentially replacing an existing loan with a new loan. There are many reasons to refinance, including getting a lower interest rate, taking equity out of a home (cash-out refinance), switching from an adjustable-rate to fixed-rate loan, or getting better terms. It can make sense to refinance if things have changed since you borrowed the money to begin with.

A Refinance Is a New Loan

Refinancing is more than adjusting your existing mortgage as it involves getting a new loan to pay off and replace the existing loan. This means you must go through the approval and underwriting process from the beginning. You will need to gather the same financial documents, search for a loan that fits your needs, and negotiate with the lender. Your credit will matter with a refinance, just as with the original mortgage. If your credit or finances have gotten worse since you took out the original loan, it may be harder to find a new loan that offers a better rate or terms.

Because it is a new mortgage, a refinance also comes with new closing costs. These costs can be thousands of dollars that are due when you close or may be rolled into your loan. It’s important to factor in closing costs when determining if refinancing makes financial sense.

Benefits of Refinancing

There are many reasons to refinance. Most people choose to refinance their loan for lower monthly payments. This can be the case if mortgage rates have significantly reduced since you took out your original loan. You may also get lower payments if you refinance into a loan with a longer term, although this will also increase your long-term interest costs.

You can also use a refinance to build equity faster. If you refinance into a loan with a shorter term, such as switching from a 30-year loan to a 15-year loan, your payments will be higher but more of your monthly payments will go toward your principal rather than interest.

When you refinance into a lower interest rate or a lower term, you can also enjoy long-term savings on interest. This can potentially save tens of thousands over the life of the loan. The longer you remain in the home, the higher your ultimate savings.

Another common reason to refinance is changing the type of loan you have. Adjustable-rate loans can be great in the beginning as they offer lower interest rates than fixed-rate loans, but only at first. These mortgages can be unpredictable with mortgage payments that may increase dramatically over time. You can refinance from an ARM into a fixed-rate mortgage for stability.

You can also access the equity in your home with a cash-out refinance. This option requires taking out a new loan with a higher balance than the remaining balance on your existing loan, but you may be capped to a loan-to-value ratio of 85% to 95%.

Refinancing Isn’t Always a Good Choice

There are situations in which a refinance will not offer financial benefits. If you have had your mortgage for a long time, for example, most of your payments go to principal to build equity rather than interest. Refinancing late in a home loan can restart the amortization process and put most of your payments toward interest.

If you plan to move in the next 5 years, refinancing may not be in your best interest. The savings you will gain from a better interest rate or lower payments may not cover the costs of refinancing.

It’s also important to understand that some mortgages have a prepayment penalty that lenders charge if the loan is paid off early. This prepayment penalty will need to be factored into other costs of refinancing to determine a break-even point.

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