The last couple of years are marked with an increased interest in loan, especially mortgage refinancing. This activity is primarily due to the decrease in loan interest rates. Having the opportunity to lower the mortgage interest rate, homeowners rushed into refinancing their original mortgage. This is so because original mortgage would have been with (much) higher interest rate. After refinancing, homeowners were able to make substantial savings. But do you know what is loan refinancing?
What is loan refinancing?
In simple words refinancing a mortgage is the process of applying for a new mortgage which will replace the existing mortgage. The same applies for any type of loan being refinanced. It could be defined as the process or a method through which you obtain new mortgage with the objective of lowering your interest rate, reducing monthly payment, cash in on your equity or change mortgage terms. These are the most common reasons, there are other reason as well.
You can chose to take new mortgage from the same bank (or lender) or from another bank. The important thing to remember here is that you can try to negotiate with your current lender (especially if you have good credit score). But, also, don’t forget to shop around for better terms.
Reasons for a mortgage refinancing
There are different reasons as to why people would like to refinance their mortgage. One reason might be due to the need for lowering the monthly payments. Lowering the cost of the mortgage loan is yet another reason why people refinance their mortgage. Some of the most common reason to refinance a loan are:
- Better interest rates – is one of the main reason as to why people refinance their mortgage. Namely, they are able to make substantial savings by refinancing original mortgage at lower interest rate. The lower interest rate can be due to improved credit score, or simply decrease in market interest rates because of economic activity.
- Convert variable interest rate into lower fixed interest rate –another reason to refinance your mortgage is the desire to convert from adjustable to fixed interest rate. If you refinance your mortgage in time of low interest rates, you can lock in the interest rate. In addition you can eliminate the insecurity in the level of monthly payments, which comes with the variable interest rate.
- Lower monthly payment – for some reason you might want to lower your monthly payment. One way to do it would be through refinancing.
- Reduce mortgage term – there are people which can afford to pay higher monthly payment couple of years after they have taken the mortgage. For this reason, they are refinancing their mortgage at a higher monthly payment (not necessarily) to reduce the repayment period of their mortgage. This way they will pay off their mortgage much faster and in a shorter period of time.
- Cash out on your equity – is a reason to refinance your mortgage if you want to have cash to make a larger purchase. Cashing out on your equity is also used for paying off some types of debt such as credit card debt.
- Consolidate debt – loan refinancing is also used as a method to cope with increased level of debt(s) or variety of debt(s). Namely, you take one larger loan to refinance all outstanding debts. Meaning that you are consolidating the different types of debt(s).
While you should understand what it means to refinance a loan, it is also important for you to understand the reason behind the refinancing actions. Is your reason for refinancing mentioned in the above list?
Aside of the reasons for refinancing, try to think for a moment about the benefits and drawbacks of loan refinancing. Have you thought of any positive or negative side of refinancing?
What are the advantages of refinancing?
Refinancing your mortgage has certain advantages for you as a borrower. Some of the common advantages are:
· Possibility to lower interest rate,
· Possibility to save money,
· Access to cash for larger purchases
· Access to cash to pay off accumulated credit card debt
· Lower monthly payment
· Faster repayment of your loan (mortgage)
What are the drawbacks of refinancing?
There are also some drawbacks when refinancing your mortgage or loans in general. You should be well aware about these pitfalls before making any final decision. Some drawbacks are:
- Costly penalties (fees) for early repayment of your mortgage
- Additional fees such as fee for legal advise
- You could end up with larger debt
Brief overview of the refinancing process
Regardless of the opinion of some people, refinancing your mortgage doesn’t have to be a complicated process. In many cases it can be a straight forward process. Of course the ease depends on many things. Things such as your credit score can have influence on possibility to get approved. Moreover, choosing the wrong bank to refinance with, could result in complication of the refinancing process.
In simple terms, the general overview of the refinancing process is as follows:
- Go through the agreement of your original mortgage – you should be aware about the terms and conditions of your original mortgage. Make sure that you understand the fees and additional charges you will have to pay in case you refinance. See if refinancing is worth the effort. Are you going to save money after you refinance? Try asking for and advice from professional.
- Shop around for adequate loan – this step is crucial because you should carefully analyse the different offers and promotions available. Don’t be lazy because there can be substantial differences from one offer to another, especially if it is about a mortgage loan. Try to find the best offer out there.
- Choose your lender – basically you have two choices either to stay with the current lender or switch to a new bank. People usually go with the bank (or lender) offering better terms.
- Applying for a refinance loan – this step is rather self-explanatory.
- Approval and documentation – you should gather the necessary document and deliver them to your bank. The bank will go through the documentation and start processing the application. If you satisfy the lenders criteria, you should be informed.
- Loan settlement – in this step title should be exchanged and the mortgage on your property is registered.
- Well done – you have finished the refinancing process. If you have applied for a cash out refinancing, this is where you should see the cash on your hand.
The cost of mortgage refinancing
You should not forget that refinancing your mortgage might turn out to be a costly process. You should understand the different fees you might have to pay if you want to refinance your mortgage or apply for a refinance loan. Some of these fees can be rather substantial amount of money as well. Consequently, common fees you might have to pay when refinancing are:
- Pre-payment penalty – is penalty for early repayment of your mortgage (or other loans for that matter). Basically, the existing lender will charge certain penalty because you are paying off the mortgage prior to the agreed maturity. Go through the agreement of your original mortgage and see if there is a penalty for early repayment.
- Application fee – serves the purpose to cover the cost of going through borrowers credit report check. The application fee charged by the lender is also covering the initial process costs of the loan. Application fee is usually up to $500.
- Appraisal fee – is fee associated with the house appraisal. Lenders require for a property appraisal in order to see if the value (and build up equity if needed) is sufficient for you to qualify for refinancing. The cost for appraising your house is usually from $300 to $500, but it can go higher or lower. On the basis of appraised value you can see whether it is smart move to refinance or not. If loan to value ratio is higher than 80% reconsider the need for new mortgage.
- Loan origination fee – is usually around 1% of the value of your loan.
- Documentation preparation fee – can be charged by some lenders, it can also be as high as $400 or more.
- Title search fee – is applied because the lender might need a title search. Commonly, this fee is around $200 to $500.
- Title insurance – to cover the potential loss of ownership interest in some property (as a result of legal problems) both the lender and the homeowner will expected the purchase of title insurance. Title insurance can cost from $400 to $800.
Going through the mortgage refinance costs you can see that the difference in interest rate is not the sole factor for deciding whether to refinance or not. There are numerous additional charges that you should pay when applying for a refinance loan. These additional fees come in the form of application costs, administration cost, appraisal costs and legal fees. All together these fees can amount to several thousands of dollars. Also, keep in mind that some lenders have hidden fees (don’t work with these lenders).
Is mortgage refinancing for everybody
Mortgage refinancing is specifically good for borrowers with high credit score. They could use the refinancing option in order to switch from variable interest mortgage to fixed interest rate mortgage. Refinancing is not recommended if you have lower credit score. But this doesn’t mean that you shouldn’t gather information to see if you’ll be better off or worse off if you decide to refinance. Always gather information before making any decisions.
Mortgage refinancing could be for you in some specific circumstances. Namely, you could consider the refinancing option if for whatever reason you know that you will not be able to afford the monthly payment. If you have decrease in your income, you can try to refinance your loans as well. Although the first thing would be to discuss with your lender to modify the mortgage terms.
Types of refinancing
There are two commonly used types of refinancing: rate and term refinancing and cash-out refinancing. Rate and term refinancing is taking into consideration (as the name implies) interest rate and terms of existing mortgage.
Rate and term refinancing
Borrower who is applying for rate and terms refinancing wants to change the features of the existing mortgage.
Your new mortgage could be for a shorter term with a lower interest rate. For instance, your original mortgage is $200,000 for a 30-years period @5.8%. You will refinance your original mortgage with new mortgage of $200,000 for a 15-year period @ 4.25%. Noteworthy mentioning is that the interest rate can be either adjustable or fixed. Replacing your original mortgage with new mortgage with lower repayment period at lower interest rate.
This means that you are changing your old mortgage with a new one with better rate and term. This should eventually lead toward saving money on your mortgage.
Cash out refinancing
Aside of the desire to change terms and rate on your mortgage, the second method i.e. cash method is used exactly as it name implies. With the cash out method you basically want to refinance your original mortgage and get cash.
For instance, your original mortgage is $250,000 for a 30-years period @5.8% (adjustable or fixed interest rate). The cash out refinance mortgage would be $300,000 for a 30-years period @4.25%. After you pay off your original mortgage you will have $50,000 cash.
With cash out refinance you will replace your existing mortgage with larger mortgage. This way you are left with cash on hand after original mortgage is repaid. Using this form of refinancing, the homeowner is using the accumulated equity.
Negative side of cash out refinance is that you will be left with higher mortgage amount than the original one. Meaning that you will increase your debt.
4 Things to consider before refinancing
There are couple of basic thing to consider before you decide to apply for loan refinancing. You should take into consideration your ability to qualify for a loan, your financial situation, reason why you want to refinance etc. In addition, try to use a mortgage refinance calculator so you would know approximately whether refinancing is worth the effort.
Ability to qualify for refinancing
It would be nice if you now beforehand whether or not you would qualify for a loan refinance. If possible, check whether the value of your home is lower than your loan amount. If it is lower, than it would be rather difficult (or very expensive) for you to qualify for a loan. Check if property value in your area has increased or decreased over the years. Don’t rush into applying just to find out that you cannot qualify.
Assess you financial situation
If the value of your home is adequate, try to make assessment of your financial situation. The aim is for you to determine beforehand, your eligibility for a refinance loan. You should check for any items on your credit report which should be removed. If your credit score is lower try to improve it. Another thing your lender will take into consideration, is your debt to income ratio. Understand this ratio and the way it is calculated. Doing this couple of things might save you both time and money.
Shop around for adequate loan
Some people rush into things and apply for the first loan they see, only to find out later that another bank offered much better terms. Thus, you need to shop around for an adequate loan. Make sure that you know what would be a good loan for you. Compare the loans from different lenders in terms of costs, repayment term, monthly payments and fees.
Mortgage refinance calculator
Mortgage refinance calculator can be a practical tool to help you in the process of deciding whether or not to you should refinance you mortgage. Of course in order to use a mortgage refinance calculator you need to know couple of things. You should know the interest rate on your current and new mortgage, monthly payment, current loan amount, as well as the refinancing costs.
Loan refinancing can be a smart move when it comes to save money on your debt, especially your mortgage loan. Mortgage refinancing is offering the possibility for lowering your interest rate, lowering monthly payment, or paying off your debt faster. But also refinancing has its own drawbacks. If you misinterpret some factors, you could end up with costly refinancing, which will mean no savings.
Consequently, if you want to enjoy the benefits of refinancing, make sure that you primarily understand what is loan refinancing. Second, understand the pros and cons of refinancing and the way the process works. Always try to gather sufficient information in order to make a wise decision. A decision which will help you to be in a good financial health.