A “refinance” refers to the replacement of an existing mortgage(s) with a new home loan. The refinance loan will come with a new interest rate (hopefully lower) and mortgage term. The existing mortgage is effectively paid off by the opening of the new refinance loan, with the old balance being transferred to the new loan.
Think of it this way – you are re-financing your mortgage, meaning you are obtaining new financing for an existing loan. When you obtain new financing, you either go back to your original mortgage lender or shop around with other banks and lenders. Either way, you’re seeking out new financing for one reason or another.
What type of refinance are you looking for?
The simplest type of refinance is called a “rate and term refinance” because the borrower is simply changing the interest rate and term of the loan, and not the loan amount (how does refinancing work?).
Usually, a borrower will consider a rate and term refinance if their current mortgage is an adjustable-rate mortgage and the fixed period is due to expire. Or if mortgage rates have dropped significantly.
An example would be a 3-year ARM. The first three years are fixed, and then the mortgage becomes adjustable, based on the margin and index tied to the loan. At or before this first adjustment, borrowers will look to refinance to avoid the impact of the fully indexed rate, assuming it’s higher than the initial rate.
Look at this example of a rate and term refinance:
Loan type: 3-year ARM
Loan amount: $500,000
Start rate: 5.875%
Fully indexed rate: 7.69%
Most short-term ARMs are hybrids. In the above scenario, the first three years are fixed and the remaining 27 years are adjustable. This may be represented as a 3/27 ARM. After three years, the interest rate adjusts to the sum of the margin and index, and can adjust every six months or annually depending on loan program specifics.
Your Mortgage Rate May Rise If You Don’t Refinance
If the borrower doesn’t refinance after three years, their interest rate will jump from 5.875% to 7.69%, using our example from above. There are initial rate caps that may limit the amount the interest rate can actually rise (or fall), but it usually won’t be sufficient to keep the mortgage rate in check.
So most borrowers will likely look to refinance their existing loan with a new loan with a longer fixed period and a lower interest rate. Homeowners have the choice of refinancing their existing loan with their current mortgage lender or shopping rates and loan programs with a new bank or lender.
It is always recommended that you shop around when looking to refinance, as rates, terms, and loan programs can and will vary greatly from lender to lender.
Consider Closing Costs Associated with a Refinance
Although there will be closing costs associated with the new refinance mortgage, the lower interest rate should eventually offset these costs and benefit the borrower in the long run. This is known as the “break-even point of the refinance” – essentially when the closing costs are offset by lower monthly mortgage payments, so subsequent payments save the homeowner money each month.
Think of it this way. If the homeowner stays in their adjustable-rate mortgage at 7.689%, they will pay $3561.01 a month in principal and interest payments. If they choose to refinance into a lower fixed-rate mortgage, say 6.5%, they’ll pay $3160.34 a month in principal and interest payments. That’s a savings of $400.67 a month.
Sure there may be closing costs associated with a refinance, but the savings will cover those costs quickly.
Those monthly savings are exactly why a homeowner would opt to carry out a rate and term refinance. Of course, if they only stayed in the home/mortgage for a year or two, perhaps they wouldn’t recoup the costs associated with the refinance. In that case, it would be a poor decision to refinance. So always do the math and look ahead before agreeing to carry out a refinance.
Why homeowners may choose to refinance their mortgage:
- To obtain a lower mortgage rate
- To fix an adjustable mortgage
- To reduce monthly mortgage payments
- To tap their home equity for cash
- To consolidate combo mortgages
- To consolidate other debt
- To pay off high-interest rate credit cards and other loans
- To remove someone from a loan (ex-spouse)
Tip: Most mortgage lenders will let a borrower take out incidental cash-out (home equity) of the lesser of 2% of the loan amount or $2,000 – $5,000, and still consider it a rate and term refinance. Anything beyond that would probably be considered a cash-out refinance., which is the other popular type of refinance available.