Many first-time homebuyers put a great deal of research and thought into choosing the right home loan for their needs. They close the deal and breathe a deep sigh of relief, assuming that they no longer have to think about their mortgage beyond making their monthly payment. After all, mortgages are long-term loans with lifespans that generally extend for decades. What more could there be to worry about? Then, the offers for refinancing begin to arrive in their mailbox. How does refinancing work?
How Does Refinancing Work?
According to Business Insider, the median home value in the U.S. in 2020 was $247,084. That’s not exactly pocket change, so it’s no surprise that few people have enough cash on hand to purchase a home outright. That is where mortgages enter the picture. When you buy a home, you take out a home loan to get the cash to pay for the property.
How does refinancing work? As NerdWallet explains, when you refinance, you pay off your old home loan with funds from a new home loan. Basically, you replace your old mortgage with a new one. In fact, the refinancing process typically works much like the mortgage application process. While the exact details vary depending on the program that you choose, you’ll likely need to apply, go through the underwriting process, and go to closing.
Reasons to Refinance
Why do homeowners opt to refinance? As Investopedia reports, there are several reasons that people decide to refinance:
- Equity: Many homeowners are interested in turning their home equity into cash to pay for schooling, make home improvements, or take advantage of investment opportunities. Others want to use it to pay down or consolidate debts.
- Loan Term: Refinancing offers a chance to change the length of the loan. For example, with a better interest rate and the same payment, you can shorten the term of your home loan; this could potentially save you thousands of dollars over the life of the loan. Alternately, you could take the better interest rate and a longer loan term and enjoy the financial flexibility afforded by having a smaller monthly mortgage payment.
- Interest Rate: Borrowers often refinance to secure a lower interest rate because it can produce substantial savings. It also tends to lower your monthly payment and increase the speed with which you build equity.
- Loan Type: Borrowers who have adjustable-rate mortgages, or ARMs, often opt to refinance to switch to fixed-rate loans because they are more predictable. They’re also less prone to soaring interest rates that can raise payments to uncomfortable heights. However, when interest rates are dropping, some borrowers who don’t mind gambling will swap out their fixed-rate loans for ARMs for a chance to ride the wave of falling rates.
Types of Refinancing
What types of refinancing options are available? As Credit Karma indicates, there are a few different possibilities:
- Rate-and-Term: With this type of refinance, the balance of the loan doesn’t change. Instead, the interest rate, the loan term, or the rate and the term change.
- Cash-In: Adding cash to your loan balance is an unusual step. However, doing so can help you get a lower interest rate, shorten your loan term, or eliminate your mortgage insurance requirement.
- Cash-Out: Taking cash out of your home means that your new loan’s balance will be larger than your previous loan’s, but it offers you a chance to receive funds and use them as you see fit.
Considerations When Refinancing
According to Experian, you have a good chance of qualifying for a loan with better terms if your credit has improved since you secured your original home loan. However, there are costs involved in refinancing. Before your commit to refinancing, have a clear idea of what your goals are. Then, make sure that the option that you are considering is a good fit for that goal and that the costs are worth the benefits.