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Refinancing 101: Mortgage Refinance Basics

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Refinancing 101: Mortgage Refinance BasicsA mortgage refinance is the replacement of an older mortgage with a new home loan that has different terms.  During the refinancing process, the existing mortgage is paid off by the opening of the new mortgage refinance loan, and the prior mortgage balance is carried over to the new loan.

Why Seek a Mortgage Refinance

People refinance their mortgages for a number of reasons, including the following:

  • To obtain a lower interest rate on a mortgage due to decreased interest rates or improved credit.
  • Increase the term of a mortgage.  This will likely reduce the monthly mortgage payment.  However, this will also increase the amount of interest paid over the life of the loan and drag out the mortgage payments over a longer period of time.
  • Decrease the length of a mortgage.  Many people refinance from a 30 year mortgage to a 15 year mortgage, since shorter term mortgages generally have more attractive interest rates, less interest will be paid over the life of the loan, and the loan will likely be paid off much quicker.  However, monthly mortgage payments may also be higher.
  • To remove someone from a loan (i.e. in a divorce)
  • Refinancing from an adjustable rate mortgage to a fixed rate mortgage to lock in a low, stable rate.
  • To get cash out of one’s home (cash-out refinancing).  If you refinance for an amount greater than what you owe on your mortgage, you may receive the excess in the form of a cash payment.  Such cash could then be used to pay off credit card debt, invest, purchase an investment property, pay for a child’s education, or make improvements on the home.  A cash out refi strips out equity that you have built up over time and turns it into cash.  A home equity loan may be another option to take out equity in a home.
  • Consolidate multiple loans into a single note.

Mortgage Refinance Alternatives

If you aren’t able to refinance, all is not lost.  As an alternative to a mortgage refinance, you could also make extra principal payments on your loan to pay off a mortgage earlier and save on interest.

Additionally, an adjustable rate mortgage, or ARM, allows you to benefit from falling interest rates without having to refinance.  However, there are serious downsides to having an ARM that should also be considered.

Requirements for a Mortgage Refinance

When you apply for a mortgage refinance, you’ll go through an application, approval, and closing process similar to when you received your original mortgage.

Many of the same requirements and costs that existed when obtaining your mortgage may also apply when refinancing.

Additionally, a lender may require that you have equity in your home before you qualify for a mortgage refinance.

How to Save when Refinancing

  • Shorten the term of the loan
  • Improve your FICO scoresAim for a score over 760.
  • Shop around and get quotes from multiple lenders to get the best possible deal.  This can save you thousands and thousands of dollars over the life of the loan.
  • Cut your PMI
  • Lock in a lower interest rate
  • Pay off your mortgage quicker
  • Ask if you qualify for any of the government’s mortgage or refinancing programs, which may save you money or help you qualify for a loan.

Disadvantages to Refinancing

There are a lot of benefits people receive from refinancing.  However, there can also be downsides to a mortgage refinance.

1.  Mortgage Amortization

For most mortgages, with each additional mortgage payment you make, more of each payment goes towards principal and less goes towards interest than the prior payment.  After a while, a significant portion of each mortgage payment may go towards your principal.

However, if you refinance, the amortization process starts over and most of each payment will again be credited against interest rather than paying down principal.  In some cases, refinancing can actually increase the time it takes to pay off a mortgage because of this, which can really set a person back financially.

Consider making the term of the new mortgage no longer than the remaining term of your current mortgage to help partially resolve this problem.

2.  Mortgage Refinance Fees

There are generally fees to refinance, just like there are fees when you take out an original mortgage.  Fees may cost up to 3-6% of the outstanding principal of the mortgage.

Some lenders tout “no-cost refinancing.”  Although definitions may vary by lender, this usually means the ability to refinance without paying any up-front fees out of pocket.  In order to receive such a deal, generally the interest rate is increased or bundled into the loan in the form of higher principal, which you will repay with interest over the life of the loan.

Does Refinancing Make Sense?

Refinancing may not make sense for everyone, even if rates do drop, due to the expense of refinancing.

Take into consideration factors such as the following when deciding whether refinancing is right for you:

  • How long you plan to own the home (it may not make sense to refinance if you will sell the home before you recoup your costs).
  • How much you can lower your interest rate.  Conventional wisdom says refinancing might be advantageous if you can knock at least 1-2% off your interest rate.
  • How many months it will take for the additional savings from refinancing to cover the fees of refinancing.  Conventional wisdom says to not refinance if the breakeven point is more than 3 years away.
  • The opportunity cost of paying closing expenses
  • Your tax situation
  • Private mortgage insurance
  • What you expect interest rates to do in the future (if you expect them to drop in the near future, it may be beneficial to refinance later).  Refinancing now reduces your ability to refinance again later.
  • Inflation expectations

Additional Mortgage Refinance Information

For additional mortgage refinance information, check out the below books:


What are your thoughts about refinancing?  Have you ever refinanced or wanted to refinance but been unable to?  What mortgage refinance tips do you have?  Leave a comment below!

Image: Scott/Bigstock

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{ 1 comment… add one }

  • Jenny November 19, 2012, 3:52 am

    I should look into this a little more. With rates as low as they are, I think it’s smart to at least see if it makes sense. Thanks!

    Reply

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