Mortgage Refinancing 101

TCR Article 3: Mortgage Refinancing 101

So you hear the term “mortgage refinancing” thrown around, but what does it actually mean? Refinancing your mortgage is a complicated process, but the benefits can be huge. Here’s what you need to know about mortgage refinancing.

What is mortgage refinancing?
Refinancing a mortgage is when you apply for a new mortgage loan that takes over your old one. Your new loan is used to pay off your previous loan, and you begin repaying your new lender. The principal balance doesn’t change — just the rate or term of your loan.

Also called rate-and-term refinancing, this type of refinancing is typically done for one of two reasons:
To get a better rate, either because market conditions have changed or because your credit has improved
To change your term; perhaps you want to switch to a shorter term to build equity faster, or maybe you’d rather move to a longer term to reduce your monthly payments

There is also a type of refinancing called cash-out refinancing. In this transaction, your new mortgage loan is larger than your original loan’s balance, and you get the difference in cash. This type of refinancing is often used by homeowners who want to consolidate and pay down high-interest debt or make expensive home renovations. But keep in mind that your home is being used as collateral, so make sure you can pay it back.

What are the benefits of refinancing a mortgage?
As mentioned above, refinancing can allow you to snag a lower interest rate, which can reduce your monthly payment and the interest paid over the lifetime of the loan. It can also allow you to adjust your term to better meet your needs. A cash-out refi gives you access to capital that can allow you to consolidate debt or make needed home improvements.

There are a few other reasons why someone may want to refinance: If you have an adjustable-rate mortgage but don’t like the uncertainty and risk of a variable rate, you could refinance to a more predictable fixed-rate loan. Or if you have an FHA loan, you could refinance to a conventional loan to get rid of the required mortgage insurance.

What are the downsides of refinancing?
While refinancing isn’t quite as complicated as applying for your first mortgage, it still requires some of the same headaches and expenses, such as getting a home appraisal, providing proof of income and other supporting documents, and paying for closing costs.

Because of this, it’s important to do a break-even calculation to see how long it will take you to pay off the closing costs and other costs of refinancing. If you plan to keep the loan for many years, you can reap major rewards from refinancing. But if you are likely to move in the next few years, it may not be enough time to cover the costs of refinancing.