Fundamental mortgage Q&A: “How does mortgage 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 mortgage term. And possibly even a new balance.
You may elect to receive this new mortgage from the same bank that held your old loan previously, or you may refinance your home loan with an entirely different lender.
It’s certainly worth your while to shop around if you’re thinking about refinancing your mortgage, as your current lender may not have the best deal.
I’ve seen first-hand lenders try to talk their existing customers out of a refinance simply because there wasn’t an incentive for them. So be careful when dealing with your current lender.
Regardless, the bank or mortgage lender that ultimately grants you the new mortgage essentially pays off your old mortgage with a new mortgage, thus the term refinancing. You are basically redoing your loan.
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 their home.
Two Main Types of Mortgage Refinancing
Rate and Term Refinancing
Original mortgage: $300,000 loan, 30-year fixed @6.25%
New mortgage: $300,000 loan, 15-year fixed @4.50%
Put 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. As noted, the motivation to do this is to lower your rate and possibly shorten the term in order to save on interest.
In my example above, the refinancing results in a shorter-term mortgage and a substantially lower interest rate. Two birds, one stone. It will be paid off faster and with far 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).
See many more reasons to refinance your mortgage, some you may have never thought of.
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.
Many have 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 existing mortgage rate. This is essentially when the refinancing costs are “recouped” via the lower monthly mortgage payments.
If you don’t plan on staying in the home/mortgage for the long-haul, you could be throwing away money by refinancing, even if the interest rate is significantly lower.
Original mortgage: $300,000 loan balance, 30-year fixed @6.25%
New mortgage: $350,000 loan amount, 30-year fixed @4.75%
Now let’s discuss a cash-out refinance, which involves exchanging your existing home loan with a larger mortgage in order to get cold hard cash.
This type of refinancing allows homeowners to tap into their home equity, assuming they have some, which is the value of the property less any existing mortgages or liens.
Let’s pretend the borrower from my example has a home that is now worth $437,500, thanks to a mix of mortgage payments and healthy home price appreciation. That would allow them to pull $50,000 out of their home while keeping their new mortgage at that all-important 80% loan-to-value (LTV).
This cash out amount is added to the existing loan balance of $300,000, giving them a new loan balance of $350,000. What’s really cool is the mortgage payment would actually go down by about $25 in the process because of the large difference in interest rates.
So even though the borrower took on more debt via the refinance, they’d actually save money each month relative to their old loan payment.
In short, 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).
While you wind up with cash, you typically get handed 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.
This is why you have to practice caution and moderation. For example, a homeowner might pull cash out and refinance into an ARM, only for home prices to drop and zap their remaining equity, leaving them with no option to refinance again if and when the ARM adjusts higher.
That being said, only pull cash out when absolutely necessary because it has be paid back. And it’s not free money. You must pay interest and closing costs so make sure you have a good use for it.
Refinancing Your Mortgage 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 and map out a plan.
If you’re not sure you’ll still be in your home next year, or even just a few years from now, a refinance might not make sense if you don’t recoup the associated costs.
Instead of borrowing more than you need, or “resetting your mortgage,” do the math first to determine the best move for your unique situation.
My refinance calculator might be helpful in determining what makes sense depending on the situation in question.
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.
But as we saw in my example above, it’s sometimes possible to get a lower mortgage payment and cash out at the same time, which is hard to beat. Just remember to factor in the cost of the refinance.
Read more: When to refinance your mortgage.