A mortgage refinance involves paying off your old loan and replacing it with a new one from a lender of your choice. People refinance for a variety of reasons, including reducing their interest rate, shortening their repayment term, and tapping into home equity to access cash.
The most important thing to know about refinancing is that it involves closing costs, so it only makes sense to refinance if the new interest rate is substantially lower than the old one. In principle, the more time that has elapsed since your initial mortgage began, the wider the gap in interest rates needs to be for a refinance to be profitable. As a rule of thumb, in the early years of a mortgage a 0.75% lower interest rate should be enough to deliver savings, while in the mid-to-late years of the repayment term, a 1-2% lower interest rate is needed. Of course, always do your own calculations before refinancing.
A standard refinance follows the same rules as a standard mortgage, with a choice of conventional loan or a government-backed loan such as an FHA loan or VA loan. Basically, you pick the mortgage product that suits you and use it to take out a new loan, replacing your old loan. The maximum loan-to-value (LTV) on a standard refinance ranges from 80-97%, depending on the lender and loan type.
A cash-out refinance is when the new mortgage is greater in value than what you owe on the old loan, allowing you to cash out the difference. A cash-out refi can be used for any purpose such as paying off debt, paying tuition fees, making home improvements, or putting money away for a rainy day.
As mentioned in the intro, refinancing involves 2-6% closing costs, just like a regular mortgage. However, there is the option of not paying closing costs through what’s known as a no-cost refinance. The way it works is that the lender agrees to waive upfront closing costs in return for your commitment to spread the costs over the life of the loan. This is a great way to obtain the benefits of a refinance without having to pay anything now.
A streamline refinance refers to the refinance of an existing FHA streamline loan (a type of FHA mortgage loan requiring limited borrower credit documentation). A streamline refinance reduces the time and costs to get a refinance. To qualify, your original mortgage must have been an FHA loan, the mortgage must be current (not delinquent), and the refinance must result in a benefit to you (by law, the lender cannot put you in a worse position in regards to the interest rate or repayment term).
Fixed-rate mortgages are the most common type in mortgage refinancing, and guarantee you a fixed rate for the duration of the loan. When you refinance with a fixed-rate loan, you pay more in year one than you would with an adjustable-rate mortgage. However, you protect yourself from the risk of having to pay a higher rate and higher monthly installments later in life.
Adjustable-rate mortgages, also known as ARMs or variable-rate mortgages, carry higher risk and higher reward than fixed rates. An ARM is always cheaper than a fixed-rate mortgage in year one, but it carries the risk of higher interest rates in the long-term. ARMs have two components: the number of years the initial rate gets locked in for; and the intervals at which rates get updated. Most lenders offer ARMs of 3/1, 5/1, 7/1, or 10/1. A 3/1 ARM refers to an ARM with a fixed rate for the first three years and a rate update every year after that. The shorter your fixed period, the better your introductory rate (and the riskier the loan). Because of their unpredictable nature, ARMs are best for borrowers with high risk appetite or borrowers who plan on selling the home or paying off the mortgage early.
Whenever a lender refinances a mortgage, they take on a certain amount of risk because there is never an iron-clad guarantee that the borrower will pay back the entire loan. The best protection for the lender is the property itself, which the lender can seize or foreclose if the borrower defaults on payments. The other way lenders protect themselves is by running a background check on the borrower – much the same as they do when approving a purchase loan.
When assessing your refinance application, the main things a lender will take into account are your credit score, loan-to-value (LTV, amount you owe as a percentage of the current appraised value of the home), and debt-to-income ratio (the monthly payment on your refinanced mortgage and other loans divided by your monthly household income). In order to assess your application, your lender will ask for various documents including social security number, pay stubs and tax returns, and recent bank statements.
Loan-to-value (LTV) is as important a factor in refinancing as a down payment is when purchasing. The LTV ratio is a term used by lenders for the ratio of a loan to the value of an asset. If, for example, your home is worth $300,000 according to the current appraisal and you have $270,000 remaining on your old loan, then your LTV will be 90%. In this instance, a lender may offer up to 97% LTV on a cash-out refinance, allowing you to cash out the remaining $21,000. Maximum LTVs can range from 80-97%, so it’s worth comparing LTVs from different lenders.
The monthly payments on a mortgage refi have two components: principal, as in the amount remaining on your loan, and interest, as in the money the lender collects for providing the loan. Your APR, or annual percentage rate, consists of the interest rate plus certain other lender fees. The lower the interest rate / APR, the lower your monthly payments to the lender.
When you refinance a mortgage, you can start your repayment term over again with a 30-year term or you can go for a shorter term if you prefer. If your financial position is better than when you took out your original loan, then one of the main benefits of refinancing is that it allows you to shorten your repayment term – putting you on track to owning 100% of your home sooner.
Like a purchase loan, closing costs for refinancing are the fees and charges owed to the lender when the loan begins and usually range from 2-6% of the loan value. Therefore, if you refinance for a loan amount of $300,000 and your closing costs are 3%, you’ll owe the lender $9,000 in upfront fees. Closing costs may include origination fees, property appraisal, title fees, taxes, and various other costs – some of which go directly to the lender and some which the lender collects on behalf of third parties. Closing costs vary from lender to lender, so knowing each lender’s approximate closing costs can assist you in doing a proper comparison.
Gone are the days when you had to walk into a physical branch to apply for a mortgage refinance. These days, the best mortgage lenders let you apply for a refinance online online, sometimes through a fully automated online mortgage platform and other times with phone assistance from a loan agent. If convenience is important to you, then keep an eye out for digital-friendly lenders.