A Beginner’s Guide to Refinancing Your Mortgage
Buying a home is probably the biggest purchase of your life. There are very few other things that come with a price tag of hundreds of thousands of dollars, and equally few things that take so long to pay off! The whole homebuying process can be enough to make first-time homebuyers’ heads spin, as there are simply so many terms and concepts that need to be understood before you can confidently close on a house. While this is the main reason that finding a good realtor is crucial, you can’t expect the realtor to simply do everything for you! While they will always operate with your best interest at heart, nobody knows your own goals, desires, and finances better than you.
One of the concepts that often gets mentioned when applying for mortgages is refinancing. Refinancing is a tactic that many homeowners employ after several years of owning their home, as it can provide drastic financial benefits. Especially as the market faces very high interest rates these days, the idea of refinancing is as relevant as ever. This post is going to explain all that you need to know about refinancing as a first-time homebuyer so that you can better imagine what to expect if you ever explore refinancing your mortgage.
What Is Refinancing?
Refinancing is the act of replacing your current mortgage with a new one that has different terms and conditions. When you refinance, the new loan may have a different interest rate, interest rate type, loan length, loan value, or some other change. While many people think that refinancing is simply changing some terms in your mortgage contract, this is a common misconception. When you refinance, your current mortgage is voided and you begin an entirely new loan. As we will discuss later in this post, refinancing your mortgage can offer significant financial benefits – including lower monthly payments and drastic savings over the life of the loan - but they do not come without a cost.
How Do You Refinance a Mortgage?
Refinancing a mortgage works pretty much the same way as getting a mortgage in the first place. To begin the process of refinancing, you need to meet with mortgage lenders and apply for a refinanced mortgage. Just like when you initially got your mortgage, lenders are likely to offer you different terms and conditions, which is why shopping around is incredibly important. Each lender will review your financial history and positioning and offer you the package that they believe is appropriate for your level of risk.
The refinanced mortgage that they offer you will be different than your initial mortgage. After all, the whole point of refinancing is to make a change! You may opt to change the amount of the loan, the interest rate, the length of the loan, the type of interest rate, or something else. While there are many reasons to refinance a mortgage, the most common one is to attain a lower interest rate.
There are certainly benefits to refinancing your mortgage, but the process doesn’t come without costs. Firstly, many refinanced mortgages’ timelines are reset to zero. So, when you take out the refinanced loan, it is likely that your 30-year window will reset. While some mortgage lenders may be willing to write you a loan that syncs up with the amount of time left on your current mortgage, odds are that you will need to adapt to the timeline of a new 15-year, 20-year, or 30-year mortgage.
On top of that, refinancing comes with literal costs as well. When you refinance, you need to pay a whole new round of closing costs, which can often total up to 5% of the value of the loan. If you are looking to sell your house sometime soon, it is possible that the costs of refinancing outweigh the benefits.
Types of Refinancing
Refinancing comes in many shapes and sizes, as it can accomplish many different goals for homeowners. Depending on the type of refinancing that you select, you may reap the benefits in the short-term, long-term, or somewhere in between. There are 8 main types of refinances:
1. Cash-in Refinance
When you choose a cash-in refinance, you opt to inject a large amount of cash into your homeowner’s equity. This is a common choice for people who come across large amounts of money from inheritances, legal payouts, or other occasions of chance. It is also a popular choice for people who were behind on their mortgage but suddenly have the ability to get back on top of their payments. When you opt for a cash-in refinance, you practically pay a second down payment that can earn you a higher percent of equity in your home and lower your interest rate.
2. Cash-out Refinance
When you choose a cash-out refinance, you walk away from the lender with a larger mortgage than you previously had. If you owed $300,000, for example, you might walk away owing $350,000. The difference is that the lender gives you the difference in cash at the moment of refinancing. This type of refinancing is a popular way to get your hands on large amounts of cash when you are in a pinch. Cash-out refinancing enables you to get your hands on tens of thousands of dollars urgently, and there is a possibility that it will not even make your monthly mortgage payment any higher. As long as you have paid enough of your current mortgage and opt for a long enough refinanced loan length, your monthly payment might stay put or even decrease.
3. Rate and Term Refinance
Rate and term refinances are for people who want to change an aspect of their mortgage but have no immediate financial need driving them to do so. While cash-in refinances and cash-out refinances help some people with immediate cash issues, rate and term refinances are usually for individuals who are in a fine financial position but can improve it by altering their mortgage. With a rate and term refinance, homeowners can seek lower interest rates or different loan terms by canceling out their current mortgage and beginning a new one. This is one of the most popular types of refinances.
If your income suddenly increases drastically and you want to pay off your house sooner, you may opt for a 15-year mortgage through a rate and term refinance. Similarly, if interest rates drop and your mortgage is written at a 7% interest rate, you may opt to refinance to take advantage of lower rates and save thousands in the long run. This type of refinancing is the one that people are typically referring to when they talk about buying a house in a high interest rate environment and refinancing it when interest rates go down.
4. No Closing Cost Refinance
No closing cost refinances allow homeowners to take advantage of new interest rates or loan terms without needing to immediately pay closing costs. As we noted before, refinancing usually requires homeowners to pay a second round of closing costs, and this type of refinancing allows homeowners to avoid this. Instead of shelling out up to 5% of the loan cost at signing, no closing cost refinances roll the closing costs into the loan and spread them out over the monthly payments. This increases the monthly payment but decreases the amount of financial pressure at signing. This is often a great option for homeowners who are looking to sell their property soon, as they can avoid some of the refinanced closing costs.
5. Reverse Mortgage
A reverse mortgage is technically a type of refinancing, but it is entirely different from every other option on this list. Reverse mortgages are only available to homeowners over the age of 62 who have a strong amount of equity in their home. When a homeowner takes out a reverse mortgage, they actually receive monthly payments from the mortgage lender rather than making them! This is often a helpful way for senior citizens to sustain themselves when they are low on income. At the end of the loan, or when the homeowner passes away, the bank is entitled to a corresponding portion of proceeds from the sale of the house to pay them back for the monthly payments issued to the homeowner.
6. Short Refinance
A short refinance is a compromise between a mortgage lender and a borrower who is on the verge of foreclosure. This is a last resort option that helps struggling borrowers to make payments and avoid foreclosure, as foreclosure is a bad thing for both the borrower and the lender. With a short refinance, the lender lowers the monthly payment and the total value of the loan to a point that the borrower can afford. While the lender loses money by doing this, they lose substantially less than they would if the house went into foreclosure. The borrower is helped with a forgiveness of part of their debt, but penalized with a hit to their credit score.
7. Debt Consolidating Refinance
A debt consolidating refinance is a popular option for people who have several different lines of debt that they are making payments on each month. Despite the high interest rates in the current environment, mortgages are generally some of the lowest interest loans that you can get, due to their high value and their long loan terms. Debt consolidating refinances are popular options for people who are in significant credit card debt, as rolling that debt into a mortgage helps to avoid the staggering interest rates that come with credit cards.
8. Streamline Refinance
Streamline refinances are only available to borrowers with certain types of federally sponsored mortgages, like VA loans, USDA loans, and FHA loans. When a borrower with one of these types of loans seeks a streamline refinance, they are able to take out a new mortgage without the need to go through several time-consuming steps of the refinancing process, like the appraisal. This type of refinance is very limited due to the restrictions on loan types, but can be very useful to homeowners who do qualify.
Reasons to Refinance
1. Refinance to decrease your monthly payment
One of the most common reasons to refinance is to decrease your monthly payment. Many people buy a house expecting their income to rise over time, and they are met with many surprises along the way. Decreasing your monthly mortgage payment can provide a little bit of relief each month, and it can be attained by lower the interest rate or lengthening the loan term.
2. Refinance to decrease your interest rate
Another one of the most common reasons to refinance is to lower your mortgage’s interest rate. Interest rates are determined by the Federal Reserve, and there is a good chance that they will decrease or increase during the life of your loan. Obviously, you do not want to refinance into a higher interest rate if you can avoid it. However, if the interest rate drops a few points after you make a few years of payments, refinancing to take advantage of the new interest rates can save you tens of thousands of dollars.
3. Refinance to pay off your home sooner
Buying a house is a huge financial commitment, and most borrowers are cautious not to take out too large of a mortgage when they buy their first home. If their income goes up after a few years and they are able to afford a higher monthly payment, they may opt to refinance to a shorter mortgage that allows them to fully own their house and stop making monthly payments sooner.
4. Refinance to relieve other financial burdens
Another common reason to refinance a mortgage is to alleviate other financial burdens. A house is likely the most valuable asset that any person owns, and its equity can be a very valuable source of collateral. Many people with mounting debts roll those debts into their current mortgage to lower the interest rate and alleviate some of the immediate pressure that comes with compounding interest and missed payments.
5. Refinance to gain financial flexibility
Certain types of refinances provide homeowners with more cash in the short-term, either in the form of decreased monthly payments or a lump sum. This money can be used to pay other expenses that would otherwise require a loan themselves, like college tuition and medical bills, or it can simply be used to enjoy life a little bit more in the present, like by going on a nice vacation.
Does Refinancing Your Mortgage Affect Your Credit Score?
Refinancing absolutely has an effect on your credit score. Your credit score is calculated based off of several factors, one of which being your loan history. Naturally, terminating one huge loan and taking out another is going to have an impact on your credit score, simply because of the size of the loans in question. On top of that, each mortgage lender is likely to do a credit check, and each credit check temporarily lowers your credit score. In most cases, the effects of refinancing are very minimal and short-lived, as it is unlikely that your new mortgage is much worse than your current one. The temporary hit to your credit score is mostly just due to the fact that big changes are occurring, and once the dust settles your score usually returns to where it was before the refinancing process started.
Thank you for reading our beginner’s guide to refinancing a mortgage. Refinancing is not for everyone, but it is a great option for many homeowners who are looking for increased financial flexibility or control. As the current interest rates are very high, there is a good chance that refinancing in the next few years could provide you with thousands of dollars of savings. With that being said, buying a house and banking on refinancing your mortgage later is not always a good idea, and you should be sure to consult with your realtor and mortgage lender before taking any drastic steps down this path.
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