Refinancing a mortgage entails replacing an existing home loan with a new one under a different agreement. Refinancing can be done for many reasons but the main one is generally to obtain more beneficial loan terms or a lower interest rate.
There are several factors to consider before deciding whether or not to refinance and, even if you choose to go that route, you should examine some details before committing to a refinancing option and lender.
We’ll Look At The Following:
- Pros And Cons Of Mortgage Refinance
- The Different Loan Options Available
- How To Determine Whether Refinancing Is Right For You
- Steps You Should Take To Prepare For The Refinancing Process
SHOULD I REFINANCE MY MORTGAGE?
When interest rates for mortgages are low, you may be tempted to refinance your home loan. But what exactly does that mean?
Simply put, a mortgage refinance means paying off an outstanding mortgage by taking out a new one, one with a lower interest rate or a shorter loan term.
There are multiple ways of doing this depending on your specific situation; when you decide to refinance, context matters.
You Should Consider Refinancing If You Want To:
- Lower Your Monthly Payment
- Obtain A Lower Interest Rate
- Shorten The Loan Term
- Remove Private Mortgage Insurance (PMI)
- Cash Out On Home Equity
- Convert From An Adjustable Interest Rate To A Fixed One (or vice-versa)
Even though these are reasonable goals, they do carry certain risks you need to understand before undertaking the refinance process.
Recognizing your needs, analyzing your finances, and calculating the total cost of refinancing will help you determine which course of action is your best bet.
First, let's go over the main refinance options.
TYPES OF REFINANCE LOANS
Although there are several types, the two main refinance options are:
- Rate and Term Refinance
- Cash Out Refinance
Rate and term refinance entails replacing a mortgage loan with a new one featuring a different interest rate, more favorable terms or both.
This is generally done for the purpose of lowering interest rates, shortening the loan term, removing PMI, or converting from an adjustable rate mortgage (ARM) to a fixed-rate mortgage.
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By increasing your credit score, you might have more bargaining power when negotiating interest rates.
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On the other hand, cash-out refinance refers to the use of your home's equity to take out a new loan for more than the amount originally borrowed.
These additional funds can be used for whatever the borrower desires, like paying off other higher-interest debts, making home improvements, or reinvesting the money for better returns.
Government-backed loans—such as Federal Housing Administration (FHA), Veterans Affairs (VA), and Department of Agriculture (USDA)—have different processes for refinancing, so it would serve borrowers with these types of loans to confirm the steps necessary for compliance.
Another option, particularly for customers with less-than-perfect credit, is the Home Affordable Refinance Program, or HARP.
This program is designed to help homeowners lower the cost of monthly payments, regardless of their credit situations or the mortgage's loan-to-value ratio (the amount owed against the current appraised value of the property).
WHAT TO LOOK FOR WHEN REFINANCING YOUR MORTGAGE
When all is said and done, refinancing should be a benefit for you, not a burden. But first, you’ve got to make sure it fits your needs and makes financial sense.
For example, if you’re thinking about refinancing to lower your monthly payment, you’ll most likely have to agree to a 30-year term. Even though you might also get a lower interest rate by refinancing, you could still end up paying more because of the extra years you’re tacking on to the original loan term.
In order to get the most out of your refinance loan, it's recommended that you calculate your break-even point. This is the number of payments you need to make in order for the savings to outweigh the refinance fees or additional payments, such as closing costs, through the revised loan terms.
A mortgage refinance can also get you out of paying private mortgage insurance. This type of insurance is required for mortgages where the down payment was less than 20%.
In a conventional mortgage, you won’t be able to stop paying the insurance until you meet the 20% equity threshold, although that’s not the case for FHA loans. However, converting an FHA loan into a conventional one will remove the insurance requirement.
Another consideration when refinancing is choosing between an adjustable (ARM) or fixed-rate mortgage. You will need to understand the difference between the two types of rates, know how long you’ll be living in the property, and have a sense of the current and future housing market.
Changing from an ARM to a fixed-rate mortgage could be advantageous because you would be locked into a given rate and wouldn't be subject to market fluctuations.
Nonetheless, adjustable-rate mortgages begin with a period of fixed rates (from 1 to 5 years) that are very favorable to the borrower. Switching from a fixed rate to an ARM may be worthwhile for homeowners who don't plan to live in the property for long.
An additional reason to opt for a mortgage refinance is to cash out on a portion of the home’s equity. A cash-out refinance can be beneficial in many ways, but it carries added risks that must be taken into account.
If you’ve been in your current mortgage for quite some time, cashing out equity could provide an excellent way to consolidate other debts (such as higher-interest credit card debt), reinvest the money in other financial instruments, or even fund a large purchase like a new car.
Although a cash-out refinance could get you a lower interest rate, the risks involved are numerous. Utilizing the extra funds to pay off high-interest debt might seem like a perfectly reasonable idea, but converting unsecured debt (credit card debt) into secured debt (a mortgage) may not be the smartest move in every case.
Failing to make your credit card payments would only affect your credit, but defaulting on a mortgage could put you in danger of foreclosing and losing your home. Furthermore, if you use the funds to acquire other financial instruments, the return might not be enough to make refinancing worthwhile.
STEPS TOWARDS REFINANCING
If, after examining the above considerations, you’ve determined that refinancing is the best course of action, you will then need to get your ducks in a row before initiating the loan request process.
Credit Score
First, check your credit report and score. Report any errors you find and clear up any disputes with credit agencies; you want to go into the loan process with the best possible score and no pending actions.
Required Documents
You will also need to get a slew of required documents including pay stubs, W2 forms, tax returns, bank and investment account statements, mortgage documentation (insurance papers and statements), and personal documents such as identifications, divorce documents, bankruptcy papers, explanatory letters for any derogatory items in your credit report, etc.
Ask Questions
Don’t be afraid to ask your lender any questions you may have regarding the refinance process. You should have a clear understanding of steps to refinance a mortgage before determining how to proceed.
Be honest about your financial standing and your needs as a borrower and ask yourself the following:
- How much risk am I willing to tolerate?
- Have I shopped around for the best rate and terms?
- Do I understand the differences between all available mortgage products and feel confident I've chosen the right one for me?
Choose A Lender
Next, you'll need to choose a lender, complete the loan application, and submit the required documentation. This will be followed by an appraisal of the property to determine its current market value and the amount of equity available. As a borrower, you'll likely have to cover the appraisal fee.
The underwriting process will begin once you've completed the above steps. Once the lender has looked over and analyzed your application and supporting documentation, you'll receive an approval letter detailing the terms and conditions of the loan. In some cases there might be a request for other necessary documentation or additional information.
If you deem the terms and conditions of your new loan satisfactory, consider locking in your interest rate. Remember that interest rates fluctuate daily, so locking them in will protect you from potentially higher rates. This comes with a cost, of course, and it will either be applied at the moment or be included with the closing costs.
Rate locks last for a specified number of days, so closing the mortgage before the end of that period will guarantee you the rate you secured. However, if it takes longer to close, other fees may apply and you could run the risk of losing the rate you locked in.
Double Check
Make sure to double check everything. If you have questions regarding your loan's terms and conditions, interest rate, fees, total costs, or anything else, this would be your last chance to clarify them with your lender or broker (which is highly recommended).
Once everything is cleared up and you’re comfortable with the loan projections, proceed to sign the documents and close the deal.
Is Refinancing Right For Me - Summing It Up
We hope this information will give you a better understanding of your refinancing options and the process it entails, yet bear in mind that nothing beats some additional research and the professional advice of real estate agents and mortgage brokers.
Before making your final decision, take a look at our list of Top 10 Best Mortgage Refinance Companies for more information on the year's most competitive lenders and rates.