How Does Refinancing Work?

August 12, 2009 No Comments »
How Does Refinancing Work?

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. And possibly even a new balance.

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

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 that grants you the new mortgage essentially pays off your old mortgage with a new mortgage, thus the term refinancing.

In a nutshell, most borrowers choose to refinance their mortgage either to take advantage of lower interest rates 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).

Rate and Term Refinancing

Original mortgage: $300,000 loan, 30-year fixed @6.25%
New mortgage: $300,000 loan, 15-year fixed @4.50%

To put it simply, a rate and term refinance is basically the act of trading in your old mortgage(s) for a new shiny one without raising the loan amount.

In my example above, the refinancing results in a shorter-term mortgage with a lower interest rate. Two birds, one stone.  It will be paid off faster and with less interest.  Magic.

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), going from an FHA loan to a conventional loan, or consolidating multiple loans into one. And in our example, to reduce the term as well (if desired).

Lately, a large number of homeowners have been going the rate and term refi route to take advantage of the unprecedented record low mortgage rates available.  They’ve been able to refinance into shorter-term loans like the 15-year fixed mortgage without seeing much of a monthly payment increase thanks to the sizable rate improvement.

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 mortgage rate.  This is essentially when the refinancing costs are “recouped” via the lower monthly mortgage payment.

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

Cash-Out Refinancing

Original mortgage: $300,000 loan, 30-year fixed @6.25%
New mortgage: $350,000 loan, 30-year fixed @4.75%

Now let’s discuss a cash-out refinance, which involves exchanging your existing 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 outstanding balance to pay back as a result (and there are 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 in most cases.  In our example, the monthly payment actually goes down thanks to the substantial rate drop, and the homeowner gets $50,000 to do with as they please.

While that may sound great, 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.

All that said, only pull cash out when absolutely necessary, because it must be paid back at some point.  It’s not free money.

Refinancing May Not Be Necessary

Despite what the banks and lenders might be chirping about, refinancing isn’t always the winning move for everyone. In fact, it could actually cost you money if you don’t take the time to crunch the numbers.

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

One alternative to refinancing your existing home loan is to instead take 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 associated interest rate and loan term, but gives you the power to tap into your home equity (get cash) if and when necessary.

Read more: When to refinance your mortgage.

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