How Does Refinancing Work?

More fundamental mortgage Q&A: “How does refinancing work?”

When you refinance your mortgage, you are essentially trading in your old loan for a fresh one with a new interest rate and term.

You may elect to receive a new mortgage from the same bank that held your old loan previously, or refinance your loan with a different lender entirely.

It’s certainly worth your while to “shop around” if you’re thinking about refinancing, as your current lender may not have the best deal.

Regardless, the bank or mortgage lender who grants you the new mortgage essentially pays off your old mortgage, thus the term refinancing.

In a nutshell, most borrowers choose to refinance their mortgage either to take advantage of lower interest rates, consolidate high-interest rate debt, or to cash in on equity accrued in the home.

Two Main Types of Refinancing

There are two main types of refinancing; rate and term refinancing and cash-out refinancing (click the links to get in-depth explanations of both).

To put it simply, a rate and term refinance is basically trading in your old mortgage(s) for a new shiny one without raising the loan amount by any extraordinary amount, usually the lesser of two percent of the new mortgage amount or $2,000.

Reasons for carrying out this type of refinancing include securing a lower interest rate, moving out of an adjustable-rate mortgage into a fixed-rate mortgage (or vice versa), or consolidating multiple loans into one.

Lately, a large number of homeowners have been carrying out rate and term refis to take advantage of the unprecedented record low mortgage rates.

Obviously it has to make sense to the borrower to execute this type of transaction, as you won’t be getting any cash in your pocket (directly) for doing it, but you will pay closing costs and other fees that must be considered.

So be sure to find your break-even point before deciding to refinance your current rate.  This is essentially when the refinancing costs are “paid back” via the lower monthly mortgage payment.

If you don’t plan on staying with the home/mortgage for the long-haul, you could be throwing away money, even if the interest rate is significantly lower.

Now let’s discuss a cash-out refinance, which involves exchanging your old loan for a larger mortgage in order to get cold hard cash.

This type of refinancing allows homeowners to tap into their home equity, which is the value of the property less any existing mortgages or liens.

Cash out refinancing puts money in the pockets of homeowners, but has its drawbacks because you’re left with a larger balance to pay back as a result (and there also the closing costs, unless it’s a no cost refi).

With a cash-out refinance, you wind up with cash, but also a higher monthly mortgage payment.

Many homeowners who serially refinanced over the past decade have found themselves underwater, or owing more on their mortgage than the home is currently worth, despite buying properties on the cheap years ago. That said, only pull cash out when absolutely necessary, because it must be paid back at some point.

You Don’t Need to Refinance

An alternative to refinancing your existing loan is taking out a second mortgage, often in the form of a home equity line of credit.

This keeps the first mortgage intact if you’re happy with the related rate and term, but gives you the power to tap into your home equity if and when necessary.

Instead of borrowing more than you need, or “resetting your mortgage,” do the math first to determine which is the best path for you and unique situation.