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How Does Refinancing a Mortgage Work?

How Does Refinancing a Mortgage Work?
4 min. read

Image: Watchara Ritjan / Shutterstock.com

The current economic climate is far from stable and many of us are feeling the pinch. You may have thought about refinancing your mortgage in order to help ends meet. However, this isn’t a decision that should be taken lightly. With that in mind, let’s take a look at how it all works.

What Is Mortgage Refinancing?

In simple terms, refinancing involves taking out a new mortgage loan to pay off, and effectively replace, your old loan. The process itself is quite similar to obtaining your first mortgage, yet there are several perks available to you the second time around.

Having a mortgage loan with a lender does not mean that you are tied to them, so you are free to shop for the lowest interest rates and best overall deals. There are, however, some differences between your first and second mortgage loans, tying in with the different types of mortgage refinancing available and their various benefits.

Types of Refinancing

Rate-and-term Refinancing

Also known as ‘no cash-out refinance’, this type of loan aims to change the interest rate, the term, or both, without making any changes to the loan amount itself. Applying for this type of refinancing can be a sensible strategy, especially when interest rates drop, as is the case in the current economic climate. It will work in your favor if you’re planning to reduce your monthly payments, or looking to switch from an adjustable to a fixed rate.

Cash-out Refinance Loan

In this case, you can tap into your home’s equity by taking out a new loan, which results in a larger loan amount that is equal to the amount you have cashed out. The new loan will essentially pay off your previous mortgage loan, and the remaining amount will be issued to you in cash. This tactic is useful if you’re looking to make money by using your home as collateral, and you can use the cash to make home improvements, pay off education or medical expenses, or even buy a second home.

Cash-in Refinance Loan

The opposite of the cash-out refinance, this type of refinancing loan occurs when the borrower brings in money to lower their mortgage balance. This tactic is useful if your home is underwater, or the amount you owe on your mortgage is higher than the current property value, and you need to regain positive equity. It’s also worth considering if you want to avoid mortgage insurance and benefit from lower interest rates.

Apart from these, there are several other refinancing programs worth checking out. The USDA, Veterans Affairs (VA), Fannie Mae and Freddie Mac (via their HARP loans), or the Federal Housing Administration (FHA) are just some organizations offering refinancing options that could prove advantageous for you.

Should You Refinance Your Mortgage?

Reduced Interest Rates

This could well be the main reason to refinance your mortgage at the moment, given the fact that interest rates across lenders are at a historic low. There will still be closing costs to contend with, but you will notice an immediate drop in your monthly mortgage payments as a result. However, refinancing in order to capitalize on low interest rates yields better results in the long run, especially if you plan to live in your current home for many more years to come.

Convert to a Fixed-rate Loan

If you have an adjustable-rate mortgage, you can use refinancing to switch to a fixed-rate loan instead. The lower introductory interest rates that come with an adjustable-rate loan typically ‘reset’ after a few years, which is why it’s best to convert to a fixed-rate loan before the reset date. With current interest rates, making the change may seem like the best course of action.

Longer Loan Terms

Let’s imagine that you’ve already spent the past 10 years or so making mortgage payments, but are coming to a point where you’re in a bit of a pinch keeping up with the monthly dues. In such cases, refinancing your mortgage can offer a lifeline by taking out a new loan for the outstanding balance and paying it off across another 30 years. It’s a long-term strategy that could work out and offer a bit of breathing space, but it’s best to keep in mind that you will be paying more interest on your loan overall.

Cash Out

Tapping into your home’s equity can be very tempting, especially given the current global circumstances. In such cases, a cash-out refinance can boost your finances, or even allow you to pay off high interest debt. The key point to address when considering cash-out is how much money you will need, and what it will be spent on. Depending on your needs, a home equity line of credit (HELOC) might work better, especially if you have smaller spendings planned.

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