Introduction
Refinancing a mortgage is a big deal. Homeowners do it during their home ownership journey. It’s replacing your current mortgage with a new loan that usually comes with different terms like a lower interest rate, change in loan term or access to home equity. While mortgage refinancing has its benefits it also has costs, risks and other things to consider. This guide will walk you through the whole refinancing process and help you decide if it’s right for you.
What Is Refinancing?
Refinancing is paying off your current mortgage and replacing it with a new loan. This new loan could have a different interest rate, loan term or payment structure. The main reasons homeowners refinance their mortgages are:
- Lower monthly payments.
- Shorter loan term.
- Switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage.
- Tap into home equity with a cash-out refi.
But refinancing isn’t always a good idea and knowing the different types of refinancing options will help you decide.
Types of Refinancing
There are several types of refinancing, each designed for different financial needs. Let’s break them down:
Rate-and-Term Refinancing:
This is the most common type of refinancing. It’s changing the interest rate, loan term or both. Homeowners do this to get a lower interest rate or switch from a 30-year mortgage to a 15-year mortgage. The big benefit is potential savings on interest over the life of the loan or faster loan payoff. But this type of refinancing still has closing costs to consider when calculating potential savings.
Cash-Out Refinancing:
Cash-out refinancing allows you to borrow more than your current mortgage balance and get the difference in cash. This type of mortgage refinancing is used to tap into home equity for things like home improvements, debt consolidation or large purchases. While cash-out refinancing gives you immediate liquidity it also increases the mortgage balance and therefore the monthly payments. And if the property value decreases you may end up with less equity in your home.
Cash-In Refinancing:
Cash-in refinancing is the opposite of cash-out refinancing. In this scenario you pay down a portion of the mortgage balance during refinancing. This can help you get a lower loan-to-value ratio (LTV) and qualify for better loan terms like a lower interest rate. Cash-in refinancing is for those who want to reduce their mortgage balance, eliminate private mortgage insurance (PMI) or get a lower interest rate. But it requires a big upfront payment.
Streamline Refinancing:
Streamline refinancing is for government backed loans like FHA, VA and USDA loans. This is a simplified process with less paperwork, no appraisal and faster processing times. The goal is to reduce the interest rate or change the loan term without all the documentation. While streamline refinancing is convenient it’s not as flexible as a full refinance and the new loan must benefit the borrower in terms of interest rate reduction or payment stability.
Private Mortgage Insurance (PMI)
Private Mortgage Insurance (PMI) is something to consider when refinancing especially if your loan to value ratio (LTV) is above 80%. PMI is insurance that protects the lender if the borrower defaults on the mortgage. It’s required when the down payment is less than 20% of the purchase price of the home.
Why It Matters in Refinancing: If your LTV ratio is still above 80% when refinancing you will likely have to continue paying PMI. This can add hundreds to your monthly payment and should be factored into your refinancing decision. But if your home has appreciated in value and your LTV ratio is below 80% then refinancing can help you eliminate PMI and reduce your overall monthly payment.
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How Long Do You Have to Pay PMI?
The length of time you have to pay PMI depends on your loan terms and how quickly you get to 80% LTV. PMI is required until 78% LTV at which point the lender is required to remove it. But you can request cancellation of PMI when you get to 80% LTV through extra payments or if your home has appreciated in value.
Early Cancellation: You can request early cancellation of PMI by paying down your mortgage faster or if an increase in your home’s value has improved your LTV ratio. An appraisal may be required to verify the current value of your home.
Automatic Termination: Lenders are required to automatically terminate PMI when your mortgage balance reaches 78% of the original property value. This termination is based on your original amortization schedule as long as you’re current on your mortgage payments.
What Is the USDA Annual Guarantee Fee?
For those with USDA loans it’s important to understand the USDA Annual Guarantee Fee which is similar to PMI for conventional loans. The USDA Annual Guarantee Fee is a percentage of the loan amount paid annually and added to your monthly mortgage payment. This fee funds the USDA loan program so the government can guarantee loans to rural and suburban homebuyers who wouldn’t qualify for conventional financing.
Refinancing: The Annual Guarantee Fee must be included in your refinancing decision. It varies but is around 0.35% of the loan balance. This fee is lower than PMI but it’s a fee that will be with you for the life of the loan whereas PMI can be removed once certain LTV conditions are met.
Can I Refinance with a HELOC?
Home Equity Lines of Credit (HELOCs) are popular for homeowners who want to tap into their home equity. If you have an existing HELOC, refinancing your primary mortgage can get a little complicated but it’s still possible.
Refinancing with an Existing HELOC: If you have a HELOC and want to refinance your primary mortgage you can. But the HELOC lender may require a subordination agreement. This agreement ensures the HELOC remains secondary to the new mortgage so the lender’s rights are preserved. Without subordination you may have to pay off the HELOC before refinancing.
Rolling the HELOC into Your Refinance: Another option is to roll your HELOC into the new mortgage through a cash-out refinance. This will simplify your finances by combining two loans into one. But you’ll also be paying off your HELOC over a longer period and potentially at a different interest rate.
Considerations:
- Interest Rates: HELOCs have variable interest rates which can change over time. Refinancing into a fixed rate mortgage will give you stability and predictability in your payments.
- Loan-to-Value Ratio (LTV): When refinancing with a HELOC your combined LTV (CLTV) must be within the acceptable limits for the new lender which may impact your refinancing options.
- Costs: Refinancing with a HELOC may involve additional costs such as appraisal fees, subordination fees and closing costs. Make sure the benefits outweigh the costs before you proceed.
Things to Know Before You Refinance
Refinancing can have its benefits but you need to be aware of these things before you proceed:
Closing Costs:
Refinancing is not free. Closing costs can range from 2% to 5% of the loan amount and includes fees such as application fees, appraisal fees, title insurance and more. Some lenders may offer “no-cost” refinancing where the closing costs are rolled into the loan balance or covered by a slightly higher interest rate. But you need to understand the implications of this approach as it may affect your overall savings.
Credit Score Requirements:
Your credit score plays a big role in the terms of your new loan. A higher credit score can qualify you for better interest rates and loan terms while a lower score may get you higher rates or limited refinancing options. Before refinancing check your credit score and improve it if necessary.
Loan-to-Value Ratio (LTV):
LTV is a big factor in refinancing. If your LTV is above 80% you may be required to carry PMI which will affect your monthly payments. And your LTV will also impact your refinancing options such as cash-out refinancing.
Break-Even Point:
The break-even point is the time it takes for the savings from refinancing to pay for the closing costs. It’s a big factor in determining if refinancing is worth it. To calculate your break-even point, divide your total closing costs by your new monthly mortgage payment. If you plan to stay in your home longer than the break-even period, refinancing might be a good idea.
Prepayment Penalties:
Some mortgages have prepayment penalties, which are fees if you pay off your loan early. Before refinancing, check if your current mortgage has a prepayment penalty, this will affect your decision.
Loan Term:
When refinancing you’ll have the option to choose a new loan term. Extending the loan term will lower your monthly payment but increase the total interest paid over the life of the loan. Shortening the loan term will save you money on interest but increase your monthly payment. Consider your goals and budget when deciding on a loan term.
Market Conditions:
Interest rates change with the market. Refinancing during a low interest rate period will save you money but you need to monitor the market and lock in a rate at the right time. Also consider the economic outlook and how it will affect your long term financial situation.
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Appraisal:
Most refinances require a home appraisal to determine the current value of your property. The appraisal will impact your LTV and subsequently your loan terms. If your home’s value has decreased it may limit your refinancing options or require you to bring cash to the table to meet LTV requirements.
Impact on Home Equity:
Refinancing especially with a cash-out option affects your home equity. While accessing equity can provide funds for various needs it also increases your mortgage balance and reduces the equity you’ve built. Consider the long term implications on your home equity and how it aligns with your goals.
Tax Implications:
Mortgage interest is tax deductible but the rules surrounding this deduction can be complex. When refinancing especially with a cash-out refinance consult with a tax professional to understand the impact on your tax situation.
Refinancing Pros and Cons Break-Even Point:
Pros:
- Lower Rates: Refinance to a lower rate and save thousands of dollars in interest over the life of the loan.
- Shorter Loan: Refinance to a 15 year loan and pay off your mortgage faster and save total interest.
- Equity: A cash out refi gives you access to your equity to use for home improvements, debt consolidation or other big expenses.
- Fixed Payments: Switch from an ARM to a fixed rate mortgage and have stable, predictable monthly payments and protect yourself from rate increases.
- Better Financial Situation: If your credit score has improved or market conditions are good, refinance and get better loan terms.
Cons:
- Closing Costs: Refinancing has closing costs which can be big. You have to weigh those costs against the savings.
- Longer Break-Even: The time it takes to recoup the closing costs through monthly savings may be longer than you plan to be in the home.
- More Total Interest: Extending the loan term even with a lower rate can mean more total interest over the life of the loan.
- Less Home Equity: Cash out refi increases your mortgage balance and reduces the equity in your home.
- PMI: If your LTV is above 80% refinancing may require PMI which adds to your monthly payments.
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Mortgage Refinancing FAQs
To help answer common questions here are some detailed answers:
How much does it cost to refinance a mortgage?
Refinancing costs can vary but are usually 2-5% of the loan amount. These costs include application fees, appraisal fees, title insurance and more. Some lenders offer “no cost” refinancing where the closing costs are rolled into the loan or covered by a higher rate but this can affect your overall savings. Always consider these costs in your refi decision.
How often can I refinance my mortgage?
There’s no limit on how often you can refinance a mortgage. However refinancing too often may not be worth it due to the closing costs. Some lenders may have restrictions on refinancing within a certain time frame, usually 6 months to a year.
Can refinancing lower my monthly payment?
Yes, one of the main reasons people refinance is to lower their monthly payment. This can be done by getting a lower rate or extending the loan term. While lower payments give you immediate relief, extending the term means you’ll pay more in interest over time.
What credit score do I need to refinance?
Credit score requirements vary by lender and loan type. 620 or higher for conventional loans, 580 or higher for FHA loans. Higher score = better rates and terms. Lower score and you can still refinance but terms won’t be as good.
Can I refinance if my home value has gone down?
Refinancing can be tough if your home value has gone down and you owe more than it’s worth, aka being “underwater”. But HARP or FHA Streamline Refinance may have options for you. Check eligibility and see if refinancing is worth it.
Can I refinance with bad credit?
Refinancing with bad credit is harder but not impossible. Government backed loans like FHA or VA loans have more lenient credit requirements. But higher rates and stricter terms. Improve your credit score before refinancing and you’ll have better loan options and savings.
How does refinancing affect my mortgage insurance?
you refinance an FHA loan and your loan to value (LTV) is over 80% you’ll still have to carry mortgage insurance. If you refinance a conventional loan and your LTV is under 80% you can eliminate private mortgage insurance (PMI) through refinancing. If your LTV is over 80% PMI may still be required and will impact your monthly payment.
What’s the difference between a cash out refinance and a home equity loan?
A cash out refinance replaces your existing mortgage with a new loan for a higher amount and gives you the difference in cash. A home equity loan is a second mortgage that gives you a lump sum of cash based on your home’s equity without affecting your original mortgage. Both have their pros and cons but come with different risks and costs so you need to evaluate which one is right for you.
How long does it take to refinance?
Refinancing takes 30-45 days but can vary depending on the lender, your financial situation and market conditions. Delays can happen due to appraisal issues, document verification or lender backlogs. Make sure you submit all required documents on time by working closely with your lender to avoid delays.
Should I refinance to pay off debt?
Refinancing to pay off high interest debt can be a good idea if you can get a lower mortgage rate. But consider the long term implications, like increasing your mortgage balance and extending your debt repayment period. And consolidating debt into your mortgage can put your home at risk if you can’t keep up.
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Conclusion
Mortgage refinancing can be a great tool for homeowners to lower their payments, shorten their loan or tap into their equity. But it’s not a decision to be made lightly. The costs, risks and benefits must be weighed against your current situation and long term goals.
Before refinancing take the time to understand the process, consider all the costs and decide if the savings are worth the effort. Talk to a financial advisor or mortgage professional to get some insight and make sure refinancing is right for you.
