Mortgage Refinancing: How It Works and When It Makes Sense

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Mortgage refinancing involves replacing your current home loan with a new one. Many homeowners do this to lower their interest rate, reduce and save on monthly payments, or tap into their home’s equity. Others might refinance to shorten the loan term, eliminate FHA mortgage insurance, or switch from an adjustable-rate to a fixed-rate mortgage.

How Does Refinancing Work?

When you originally buy a home, you secure it with a mortgage where the lender provides funds to the seller, and you repay the lender over time. Refinancing involves getting a new mortgage that pays off your existing home loan. Instead of the lender paying the home seller, it clears your old loan’s balance. You’ll then repay the new lender based on the new mortgage terms. The refinancing process mirrors that of getting a purchase mortgage, requiring an application, underwriting, and closing.

When to Refinance a Mortgage

If current mortgage rates are lower than when you initially secured your loan, refinancing can save you money by reducing your interest rate and monthly payments. However, if rates have increased since you bought your home, refinancing might not be beneficial unless it serves another purpose like eliminating FHA mortgage insurance. Your credit score plays a crucial role in the rates you’re offered. Improved credit since purchasing your home can also lead to better refinancing rates.

Common Reasons to Refinance

Reduce Monthly Payments: Refinancing to a lower interest rate can decrease your monthly mortgage payment, making a rate and term refinance suitable for this goal.
Pay Off the Loan Faster: Switching from a 30-year to a 15-year mortgage can save you interest over the loan’s lifespan but usually increases monthly payments. Alternatively, making extra payments on your current loan can expedite repayment without refinancing.
Extend the Loan Term: Extending from a 15-year to a 30-year mortgage can lower monthly payments but increases the total interest paid over time.
Tap into Home Equity: A cash-out refinance allows you to tap into home equity and borrow more than your current loan balance, providing cash for the difference. Depending on your credit and current rates, you might even secure a lower interest rate.
Eliminate FHA Mortgage Insurance: If your FHA loan requires mortgage insurance premiums for its duration, refinancing to a conventional loan with at least 20% equity can eliminate this cost.
Switch from Adjustable-Rate to Fixed-Rate: Refinancing from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage can offer stability with consistent payments, especially if ARM rates are rising.

Costs of Refinancing

These costs are similar to those of a purchase mortgage, typically ranging from 3% to 6% of your outstanding principal. For instance, if you owe $200,000, expect refinancing fees between $6,000 and $12,000. Always review your original mortgage for any prepayment penalties.

Finding the Best Refinance Rates

Shop around to get Loan Estimates from at least three lenders. Each lender must provide this document within three days of receiving your basic information, detailing loan terms, payments, closing costs, and fees. Use a Refinance Calculator to compare the terms of the new mortgage with your existing one to determine potential savings on monthly payments or total interest. Calculate Your Break-Even Point to understand how long it will take for your monthly savings to offset the costs. This calculation helps determine if refinancing is financially beneficial.

Steps to Refinance

-Set Your Goal: Determine whether you want to lower payments, shorten the loan term, eliminate mortgage insurance, or achieve another goal. This helps identify the best refinancing option.
-Apply to Multiple Lenders: Submit applications within a two-week period to minimize credit score impact. Multiple inquiries within this timeframe are considered as one for scoring purposes.
-Choose a Lender: Compare Loan Estimates to pick the best offer, considering closing costs and fees.
-Consider Locking in Your Rate: Locking your interest rate can provide stability during this process, ensuring it doesn’t change before closing.

Pay closing costs and finalize the loan to close it. This is similar to the original mortgage closing process, but without the need to transfer home ownership. This process can be a smart financial move under the right circumstances, offering potential savings and better loan terms. However, it’s crucial to understand the process, costs, and benefits to make an informed decision.

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