Refinancing a home loan means to pay off the current loan and take out a new one. What refinancing is not: taking out a second mortgage or a home equity loan. When you refinance, the bank gives you a brand new mortgage that makes it possible to pay it off more quickly or at less overall expense than your current mortgage.
People refinance their loans when they are cash-strapped and are having trouble paying the monthly bill, and also when they are in good financial health and want to make it better still.
There are many financing and credit options available to homeowners, and refinancing a home mortgage might sound confusing when there are so many choices. Here you will learn about the process of refinancing and how it can help you and your financial health.
Why Would You Want to Refinance?
The most common reasons to refinance a home loan are:
- To reduce the monthly payment
- To reduce the total cost of the loan – that is, the amount of principal + interest you’ll have to pay over the life of the loan
- To shorten the length of the loan
- To change the rate type (say, for example, from adjustable rate to fixed rate)
- To take out cash to pay for other expenses or debt
- To stop paying private mortgage insurance premiums (insurance you will have to buy to protect your lender if your down payment or amount of equity is less than 20% of your home’s value)
There are three types of refinancing to become familiar with:
- Rate-and-Term refinancing
- Cash-Out refinancing
- Cash-In refinancing
What Is Rate-And-Term Refinancing?
Rate-and-term refinancing for a home loan is done to change one or both of two things: (1) the interest rate of the mortgage and/or (2) the terms of the mortgage (typically, the length).
One of the most common reasons to refinance is to lower the interest rate on your home. When the interest rate goes down, so does the amount of the monthly payment, and when the monthly payment goes down so does the overall cost of the loan. Here is an example:
| Amount of the Loan (20-year) |
Interest Rate |
Monthly Payment |
Total Cost of the Loan (Principle + Interest) |
Total Savings |
| $200,000 |
6.5% |
$1,491 |
$536,760 |
|
| $200,000 |
4.5% |
$1,265 |
$455,400 |
$ 81,360 |
This refinance at a lower interest rate results in a monthly savings of $251 and a total overall savings of $90,360. Those who find the current monthly mortgage payment of $1,264 to be too high will get relief because of the monthly savings, and those who can afford the current payment will still benefit by saving more than $80,000 over the course of the loan.
Another way to make a positive change to the cost of the loan would be to reduce the length of the loan from 30 to 20 years. Using a 6.5% interest rate, the numbers look as follows:
| Amount of the Loan (6.5%) |
Number of Payments |
Monthly Payment |
Total Payments |
Total Savings |
| $200,000 |
360 |
$1,264 |
$ 455,040 |
|
| $200,000 |
240 |
$1,491 |
$455,400 |
$97,200 |
For purposes of the illustration, the interest rate for both potential loans has remained the same. In fact, though, if you were to take out a new mortgage for a 20-year term instead of a 30-year mortgage, the interest rate would likely come down, allowing you to save both ways.
What Is Cash-out Refinancing?
Let’s say you want to refinance your mortgage to get a better interest rate, and you also want to buy a $50,000 new car. Your house is worth $400,000 and the current principal balance on the mortgage (the amount you owe and need to borrow) is $150,000. In a cash-out refinance, you will borrow more than the amount you owe on the house – say, $200,000. This amount will give you enough money to pay off the current mortgage, and also $50,000 extra to buy the car you want.
The bank is happy to do this because the more you borrow from them, the more money they make in the collection of interest from you. You can use the supplemental cash for anything you want – to pay for a child’s college tuition, to take a vacation, or to buy that car that you had in mind. One reason to use the equity you have in your home to pay for such things as tuition, vacations or cars is that the interest rate on a home loan is usually a good deal lower than the interest rate on the other types of loans you would have to take out to pay for such items – personal loans or auto loans, for example.
Banks place a limit, however, on the amount you can cash-out refinance. Typically they will lend only up to 80% to 85% of the current value of your home. In the case above, they would be willing to lend you the full $200,000 because that is only 50% of the value of your home.
What Is Cash-in Refinancing?
If you should somehow come into possession of a lot of cash, that’s a good time to refinance your house. A cash-in refinance allows you to pay a lump sum toward home equity, reducing the remaining loan amount. Often you can obtain a better interest rate (since you are now borrowing less). By reducing the amount of interest you will pay on the mortgage, cash-in refinances will lower the total cost of the mortgage (principal + interest).
If you are paying personal mortgage insurance because of currently having low equity in the home, if you pay off a large enough piece of the mortgage with a cash-in refinance, you may be able to get rid of the personal mortgage insurance payments completely. That alone can save you hundreds of dollars a month, and thousands of dollars over the life of the loan.
Can I Use Refinancing to Avoid Foreclosure?
Yes. Refinancing is one of several ways to avoid foreclosure. Refinancing because of financial problems works the same way as refinancing when you are doing well financially. However, when you are nearing the possibility of foreclosure, your credit history will make it unlikely that the bank will allow you to refinance at a lower interest rate, as was the case described earlier.
Instead, refinancing to avoid foreclosure will leave you with a higher interest rate, but it will provide you with much needed time to either sell your home to pay off the loan in its entirety, or to gather more money to get back on the right track.
How Much Does it Cost To Refinance a Mortgage?
Typically, mortgage refinance closing costs range from 2% to 6% of the loan’s principal. On a $200,000 loan, for example, refinance closing costs might be $4,000 – $12,000. You can pay those costs out-of-pocket or, in most cases, you can roll these costs into your new refinanced loan.
Should I Consult a Lawyer About My Refinancing Issues?
Buying and financing a piece of real estate can be one of the most complicated financial decisions you make. A financial attorney can advise you of the different mortgage financing options for this endeavor. An attorney can also review any documents that you are asked to sign, and can advise you concerning your rights and obligations and the best way to proceed.
It is also possible that a dispute could arise between you and your lender, giving rise to a lawsuit based on mortgage issues. If you run into an issue with the mortgage and need to sue, a qualified lawyer can explain to you what rights you have against your lender, can represent you in court, and can help you get the best possible outcome.
