Mortgage refinancing is the process of replacing a mortgage with a new one that offers more favorable terms. The homeowner takes out a new loan with better terms and uses the proceeds to pay off the original mortgage. Many homeowners refinance their mortgages because interest rates have dropped or their credit has improved to a point that qualifies them for a lower interest rate. Refinancing can save you money and help you accomplish financial goals, but there are also potential drawbacks. It’s important to consider the benefits, costs, and risks before you choose to refinance.
Why Should I Refinance My Mortgage?
It’s important to start the refinance process with clear goals. If you know exactly what you want to achieve by refinancing, it will be easier to evaluate your options.
- Many homeowners refinance to get a lower interest rate on their mortgage. If your credit has improved since you got your mortgage or if market rates have dropped you may be eligible for a lower interest rate, which can provide significant savings over the life of the loan.
- Some homeowners refinance to lower their monthly mortgage payments. If you have already paid off a portion of your mortgage, taking on a new mortgage to cover the remaining balance can lengthen your loan term and spread that amount over a longer period. This may produce a more affordable monthly payment.
- If you plan to remain in your house for some time and your original mortgage has an adjustable rate, you may wish to replace it with a fixed-rate loan to avoid a potential interest rate increase if the prevailing market rate rises.
- If you bought your home with an FHA mortgage, you may be paying a monthly mortgage insurance premium. If your credit has improved and you now qualify for a standard loan, you may wish to refinance to dispense with that monthly payment.
- Couples with a joint mortgage sometimes refinance as part of a divorce, to remove one partner’s exposure to the loan.
- If you have paid enough of your old mortgage to have substantial equity in your home, cash-out refinancing allows you to tap that equity if you need cash for other purposes.
What Type of Refinancing Should I Consider?
Once you’ve established your refinancing goals, you’re ready to decide what type of refinancing you need to achieve them.
- Rate-and-Term Refinancing changes the term or interest rate of your loan balance without changing the amount. This allows you to take advantage of a lower rate or extended term, or to switch your existing adjustable-rate loan to a new fixed-rate loan.
- Cash-Out Refinancing replaces a mortgage with a new loan in a larger amount. The homeowner takes the difference between the two amounts in cash. This allows the homeowner to use a portion of their equity to meet other financial goals. Homeowners often use cash-out refinancing to finance repairs that will increase the value of their home or to pay off higher-interest loans and replace them with a single relatively low-interest loan.
- Cash-In Refinancing involves adding cash to the deal to produce a new mortgage that is smaller than the old one. Homeowners use cash-in refinancing when they have cash available and they wish to lower their interest rate, reduce their total debt burden, or avoid the need for mortgage insurance. It may also be used by homeowners who want to avoid owing more on their home than it is worth.
How Do I Refinance My Mortgage?
Start by checking your credit score and report. It’s also a good idea to do some research on interest rate movements since you got your mortgage. If your credit has improved and interest rates have dropped, it could be a good time to refinance. If your credit has not improved or rates have risen, it might be better to wait.
If the timing is right, you’re ready to start shopping for loans. This process will be much like the loan shopping you did when you took out your first mortgage. You will ask several lenders for offers, compare them, and select the one with the best terms.
Be sure to do all of your loan shopping within a two-week period. Loan shopping will generate hard inquiries on your credit report. If these inquiries are made within a limited time period, the credit reporting companies will treat them as a single inquiry, which can prevent damage to your credit.
When you’ve chosen the best current offer, compare it carefully with your existing mortgage. If your refinancing goal is interest rate savings, you will need to calculate what the new rate will save you over the lifetime of the loan. Be sure to consider the closing costs of your new mortgage in your calculations. If your old mortgage has a prepayment penalty, you will need to include that cost as well. Review the terms of the old and new loans carefully to make sure you aren’t missing anything.
Will I Qualify for a Refinance Loan?
Refinancing a loan involves a qualification process similar to the one you went through when you applied for your original mortgage. Your lender will consider your credit score, your debt-to-income ratio, your home’s current value, and the amount of equity you have in your home, among other factors.
The rate you are offered on your refinancing loan will be based on the level of risk the lender believes you pose. If your credit and your finances have changed since you got your original loan, you may be offered better terms. If your credit has dropped or you’ve taken on new debt, you may not be offered a better deal. The rate you are offered will also be affected by prevailing market interest rates.
What Are the Risks of Refinancing?
There are potential pitfalls that you have to consider before you decide to refinance.
- The interest rate you are offered will depend on your credit and on the prevailing market rates. Even if your credit has improved since your mortgage, you may not be offered a better rate if market rates have gone up.
- The costs of closing your new loan may equal or even exceed your savings from a lower interest rate. You have to be sure that you are not overlooking any costs that could affect your cost-benefit calculation.
- If there’s a possibility that you may sell your home soon, it might not be the right time to refinance. The costs of refinancing are immediate and the savings are realized over the life of the loan. If you sell your home soon after refinancing, you may not save enough to cover your closing costs.
- Lengthening your loan term can lower your monthly payment, but you may take longer to pay off your mortgage and the longer-term can increase the total amount of interest you will pay. In some circumstances the additional cost may be justified. If you have suffered a loss of income and you’re having a hard time making payments, a lower monthly payment could keep you from missing a payment and damaging your credit. You should still be aware of the potential costs.
- Cash-out refinancing can leave you with more debt than you had before your refinance and may increase your monthly payment. Your interest rate could also increase.
- If you’re using cash-out refinancing to pay off credit card debt and replace it with a lower interest loan, you will need the discipline to change your spending habits. If you don’t, you could end up with both a bigger mortgage and a new mountain of credit card debt.
How Will Refinancing Affect My Credit?
Refinancing can affect your credit in several ways.
- Your new loan will generate a hard inquiry on your credit report. The impact of a single inquiry is usually minor and temporary. Be sure to keep your loan shopping within that 2-week period to avoid generating multiple hard inquiries.
- Paying your old mortgage and taking on a new one could reduce the length of your credit history. That could have an impact on your credit, especially if you have a short credit history with a limited number of accounts.
- Pay special attention to the transition between the old mortgage and the new one. Missing a payment during the transition could have a serious impact on your credit, even if you pay off the entire loan soon after.
Always keep track of your credit, especially if you’re planning to negotiate a major loan such as a mortgage refinance. Monitor your credit through the entire process. Check your credit report after the refinance is concluded to be sure that the new status of your mortgage is accurately reflected.
Is This the Right Time to Refinance?
Refinancing a mortgage can be a good decision or a bad one, depending on your specific goals and circumstances. Having a clear picture of what you want to achieve by refinancing and what terms you will have to get on your new mortgage to meet those goals will help you make the right decision.
It is important to have a clear and complete comparison between your old mortgage and the proposed replacement. You need to consider all potential costs. If you’re not sure the deal you’re getting will achieve your objectives, consider consulting a professional financial advisor.
Refinancing is a major decision that will affect you for many years. Approaching refinancing with a clear strategy and explicit goals will help you to make the right decision for your future.
