In the mortgage realm, 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 (ideally 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. The issuer of the new mortgage pays off the old loan with the proceeds from the new loan so everyone is square.
When you obtain new financing, you can either go back to your original mortgage lender or shop around with other banks and lenders. Generally, it’s best to see what other lenders can offer. Either way, when you refinance you are seeking out new financing terms for one reason or another.
What type of refinance are you looking for?
The simplest type of mortgage refinance is called a “rate and term refinance” because the borrower is simply changing the interest rate and term of the loan, and perhaps the loan program, but not the loan amount. It may also be known as a “no cash out refinance” for this reason.
Typically, 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 since they originally took out their fixed-rate loan.
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 often 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 in action:
Loan type: 3-year ARM
Loan amount: $500,000
Start rate: 2.875%
Fully indexed rate: 4.25%
Most short-term ARMs are hybrids with 30-year terms. In the above scenario, the first three years are fixed and the remaining 27 years are adjustable. This may be represented as a 3/1 ARM. After three years, the interest rate adjusts to the sum of the margin and index, and can adjust annually both up or down.
Instead of getting stuck with a higher rate, the borrower can obtain new financing that is lower than the fully-indexed rate.
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 2.875% to 4.25%, 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 in a rising rate environment.
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. Or simply refinance into another ARM with an initial teaser rate.
If you happen to be replacing a fixed-rate mortgage with another fixed-rate mortgage, you may want to shorten the term while you’re at it, assuming you want to pay off the loan on schedule. Otherwise you’ll be looking at a fresh 30 years on the new loan.
Of course, a shorter term will require a higher monthly payment in most cases, so it’s not always a viable option. Sometimes it’s good enough just to get the rate and associated monthly payment down.
It is always recommended that you shop around when looking to refinance, as rates, closing costs, underwriting requirements, and loan programs can and will vary greatly from lender to lender over time.
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 4.25%, they will pay $2459.70 a month in principal and interest payments. If they choose to refinance into a lower fixed-rate mortgage, say 3.5%, they’ll pay $2245.22 a month in principal and interest payments. That’s a savings of about $215 a month.
Sure, there may be closing costs associated with a refinance, but the monthly savings will cover those costs over time. Additionally, you might even be able to execute a no cost refinance whereby you pay no closing costs in exchange for a slightly higher-than-market rate, but still receive a rate well below your existing one.
These 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 Refinance Their Mortgages
- To obtain a lower mortgage rate
- To swap an ARM for a fixed 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)
- To remove mortgage insurance
- To switch loan programs, such as FHA to conventional
- To shorten the term and pay off a loan faster
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 mortgage refinance available.