Refinancing a mortgage can free up money for homeowners in a couple of ways, either by reducing their monthly payments or by substituting a new mortgage in an amount higher than that of the original mortgage. This guide will help explain when, why, and how to refinance your current mortgage.
What is mortgage refinancing?
Mortgage refinancing is the act of replacing your current mortgage with a new one. The lender of the new mortgage pays off the previous mortgage, leaving the homeowner with a new mortgage. The process of applying for and receiving a refinance is generally the same as for a standard mortgage, meaning you still need to get an appraisal, submit supporting financial documents and pay closing costs.
The primary reason for refinancing a home is to save money. The terms of the new mortgage, while they can be completely different from those of the old mortgage, are ideally more favorable to the homeowner. While a lower interest rate is the most common savings, the other terms in the new mortgage can also financially benefit you as a homeowner.
What is cash-out refinancing?
Cash-out refinancing is a type of refinance in which the loan amount on the new mortgage is greater than the balance on the current mortgage. In this case, the homeowner receives the difference between the two in cash. Assume for this example that your house originally cost $200K. You've already paid off $50K, leaving you with a balance of $150K. Now assume that you're able to obtain a cash-out refinance for $175K, meaning that you will receive $25K in cash after the first mortgage is paid off.
You can then use that cash for any purpose you like, although financial advisers recommend that you use it for something that provides a positive return on investment (ROI). This includes a home improvement that will increase the value of your home. Another common use of the funds from a cash-out refinance is to pay off high-interest debt such as credit card balances.
Homeowners can also refinance if they bought a house for less than its appraised value. Assume for this example that you paid $200K for a house that was worth $250K. You've already paid $100K on the original mortgage, leaving a balance of $100K. Since the difference between the value of your house and what you owe on it is $150K ($250K - $100K), you could qualify for a cash-out refinance that will provide you with as much is $50K in cash.
Why should you refinance your mortgage?
A refinance can provide several specific financial benefits such as a lower interest rate, smaller monthly payments, and the choice of either a fixed or variable rate, either of which could be valuable depending on the direction of interest rates.
Lower interest rate
The best time to refinance your mortgage is when mortgage rates are lower than the original mortgage, offering the opportunity for savings. Bear in mind that your savings in interest costs needs to be greater than the closing costs of the refinance if you are to realize a net savings. Typically, a reduction in the interest rate by ½ to 1 percentage point is sufficient to consider refinancing.
A couple of options exist for handling a reduction in your interest rate. The method that provides the greatest long-term savings is to simply continue making the same monthly payments, allowing you to pay off your mortgage more quickly. On the other hand, you can use the interest rate reduction to lower your monthly payments, which might be necessary if you've been having trouble making your current payments.
Different interest type
You can also save money through a refinance by changing the type of interest rate. The interest rate on a mortgage may be fixed or variable; a fixed interest rate remains constant throughout the term of the mortgage, but an adjustable rate mortgage fluctuates based on a market indicator such as the prime interest rate. A fixed rate is best when interest rates are rising, while an adjustable rate is better when interest rates are falling.
Assume for this example that interest rates are high when you take out a first mortgage, so you opt for an adjustable rate. Later, interest rates drop to a very low level. You can then use a refinance with a fixed rate to lock into a lower rate.
Why should you refinance for a shorter term?
Lenders generally charge a lower interest rate for mortgages with a shorter term because they receive the full return on their investment in less time. You can use this rule to save money by refinancing for both a shorter term and a lower rate.
Assume for this example that you had a relatively low income when you took out your original mortgage. You needed a mortgage with a standard 30-year term to minimize your monthly payments. Later, your income increases to the point that you can afford significantly higher monthly payments. In this case, it might make sense to refinance for a shorter term, perhaps 15 years.
What is the break-even point?
The break-even point is the point in time at which the savings on your refinance is equal to the cost of refinancing. In other words, the break-even point is the time it takes for the refinance to pay for itself. Closing costs vary greatly by lender, but they typically add up to thousands of dollars. A refinance may not be worth it if it takes too long to reach the break-even point, even if it will eventually save you money.
Assume for this example that a refinance will save you $150 a month on your payments, and the closing costs are $3K. It would take 20 months to reach your break-even point, meaning you would need to remain in your house for at least 20 months before a refinance would pay for itself. If you don’t plan to remain in your house for at least that long, then perhaps a refinance is not for you.
