Everything you want to know about refinancing: what is it, how it works, and why do it
Your home is likely your biggest investment and refinancing is the best way to cash in on some of its value without selling it. Each type of refinancing option is different, but they all work by taking out a new loan with different terms to pay off an old one. This is how you can lower your monthly payments, take out lines of credit against your home, or even gain access to your home’s cash equity. Which type of refinance you choose and how you use it depends on your goals. We’ll go over everything you need to know before refinancing.
What is refinancing?
In short, when you refinance your mortgage you apply for a new mortgage loan and use it to pay off your original mortgage(s). People do this for a variety of reasons, but the point is to start a new loan with terms that suit you better for your current financial needs. Depending on the type of refinancing, you can save money with new mortgage rates, save money on interest, or even access the equity you have tied up in your home as cash.
We already mentioned that there are a lot of good reasons to refinance your home loan. No matter what, though, the point of any refinance is to get more from your investment and to capitalize on the value in your home.
- Lower your interest rate
When you first bought your home, interest rates may have been higher than they are now for any number of reasons. If they’re lower now, you can refinance into a mortgage with lower rates and save money over the course of the loan term.
- Change the loan term
Shortening the loan term may lead to a higher monthly payment, but it also cuts down on the total interest. If you can afford a higher monthly payment now, and intend to stay in the home for the duration of the new loan term, shortening the time it takes to pay off may save you money in the long run.
- Change the type of loan
Some types of mortgage require Private Mortgage Insurance (PMI). In most cases, PMI is automatically canceled when the home reaches a certain amount of equity, but you can avoid PMI earlier if you refinance to a type of mortgage that doesn’t require it.
- Get cash back or open a line of credit
If you have enough equity in your home—which is the amount between how much you owe on your loan and how much your home is worth— you can apply for a cash-out refinance. Your lender will underwrite a new mortgage for the new, higher value of the home and you’ll have cash left over once you pay off the smaller, original loan amount. You can also open a home equity line of credit (or HELOC) where a lender will set aside a set amount of money determined by your equity that you can borrow as needed and pay back with interest, like a credit card. But this isn’t strictly a refinance because it’s not a new, single loan, but an additional payment on top of your mortgage.
How does refinancing work?
Refinancing works very similarly to how taking out your first mortgage worked. Just like when you were first approved for a mortgage, you’ll need to apply, get approved, and then underwritten for the new loan by providing documentation of your finances. You may want to consider a rate lock if your lender offers one, but this depends on your location, the market, and your loan type.
Your lender will also order a home appraisal, which you’ll need to pay out of pocket for, so they can be sure they’re loaning an appropriate amount of money. Read our full guide on home appraisals here.
Then, you’ll close on the new loan and pay any associated fees your lender requires.
The different kinds of refinancing
There are two basic kinds of refinances, rate-and-term refinances and a cash-out refinance. Both are designed to pull value out of your home in different ways.
A rate-and-term refinance is exactly what it sounds like: it allows you to change your rate and the term of your loan. Borrowers can take advantage of a lower interest rate or even change the type of loan altogether to save money on monthly payments or to cancel PMI. This is most commonly done when interest rates lower or when a borrower decides to go from an adjustable-rate mortgage to a fixed-rate mortgage.
A cash-out refinance requires a minimum of 20% equity in your home. Your lender will give you a loan for the amount your home is worth now, after it’s appreciated in the market since your original mortgage. Once you pay off the original mortgage, you’ll have cash leftover since the new loan is higher.
When is the right time to refinance?
Because every financial situation is unique, it’s difficult to pinpoint a recommendation that will work for most homeowners.
You can always reach out to your lender for a quote. Our rule of thumb at Flyhomes Mortgage is that you should be saving at least 0.25% off of your current interest rate for a rate and term refinance to make sense.
On top of interest savings, it’s important to consider how much it will cost to close the refinance (common fees include an underwriting or processing fee, appraisal fee, and title and escrow fees). To offset these closing costs, we typically recommend that our clients consider taking a slightly higher interest rate that usually comes with a lender credit large enough to cover all of the associated closing costs.
The other option would be to roll the costs of the refinance into the new loan. Take note that this option increases the amount of principal owed, which increases your monthly payments.
If you’re looking into a cash-out refinance to pull some equity out of your home, you can consider doing that once you have a need for those additional funds.
At Flyhomes Mortgage, we monitor our customers’ loan terms to provide suggestions on when the right time to refinance might be.
What do I need to get a quote?
No matter which bank, lender, or mortgage broker you work with, you’re going to need to provide basic details. It’s easiest to have a copy of your most recent mortgage statement on hand, but if you don’t, here are the items you’ll need for a mortgage lender to get started:
Estimated current value of your home
Current interest rate
Principal balance left to pay
Your approximate credit score
How do I know if I’m getting a good deal?
First, consider your new interest rate—how does it compare to your current one? What’s the difference in your monthly payments with this new rate?
All refinances come with closing costs, too. Find out how much you’re expected to pay to close your new loan with your new lender.
If there are any costs associated with your refinance, compare how much you are paying up front against how much you’ll save monthly. For example, if you’re paying $1,000 in closing costs for a refinance in order to reduce your monthly payment by $50 per month, you’ll need to pay your mortgage for at least 20 months before you’ll actually start to see the savings.
Shop around with different lenders to make sure you are getting the best deal. Just be sure that you’re comparing apples to apples when you look at your quotes.
What does refinancing do to my credit?
Just like when you first applied for a mortgage, the bank will pull a hard inquiry on your finances and that will push your credit score down a few points. But as long as you make your payments on time, the effect will be temporary—just a few months.
Refinancing is the most common and most powerful tool for homeowners to start collecting on their real estate investment, whether it’s by changing their monthly payment or liquidating some equity. There are many different types of refinancing and even more reasons you may want to do it. Understanding how refinancing works will help you get the most out of your real estate investment.