Refinancing is the financial technique of adjusting, replacing, or changing the terms of a loan or mortgage.
Whether you’re a real estate professional or just want to refinance, I’ve got you covered. I’ve been in the real estate industry for years, and refinancing is constantly misunderstood, even though it’s an essential real estate concept.
In this post, I’ll define refinancing and explain how borrowers can benefit from this financial tool. Let’s dive into the details!
What Is Refinancing?
Refinancing a loan is the process of revising an existing loan with different rates or loan terms. Borrowers mostly refinance their loans to lower interest rates and reduce their monthly payments. Refinancing is a useful financial tool for borrowers struggling to pay off their loans. Some borrowers also use this tool if they want a longer term with small monthly payments. However, with a long-term loan, the total cost of the loan will increase as the borrower will have to pay interest for a long time. In short, refinancing is done to get a better deal on a loan than the existing one.
The borrower generally wants to decrease, increase, or maintain the same loan amount when refinancing. In case of an increase in the loan amount, the borrower benefits from debt consolidation by paying off the debt quickly and freeing up more cash for home renovations or other expenses. Decreasing the loan amount means the borrower wants to secure a lower interest rate by reducing the loan term. It isn’t necessary to decrease the loan amount through refinancing; the borrower can also decrease the loan amount by paying a lump sum to the lender.
Lastly, the borrower keeps the loan amount the same through refinancing to get a better deal. Through this option, the borrower can switch from a fixed-rate mortgage to an adjustable-rate mortgage or vice versa. Chances are that the borrower has improved their credit score by making timely payments, and now they want a better deal. The following are the different types of refinancing options:
Cash Out Refinance
A cash-out refinance the individuals to access the equity in their property and borrow against it. Cash-out refinance is common when the property used as collateral in the mortgage has increased in value. The borrowers can borrow against this equity and use the cash for meeting any expense, such as home renovation or repair. Cash-out refinance is useful as it allows the borrower to enjoy the benefits of their increased property value. When the property increases in value, the borrowers can take a loan for that value instead of selling it. Though this option increases the loan amount, it allows the borrower to keep the ownership of their property.
With a cash-out refinance, the borrower is taking cash from their property, increasing the new loan’s principal balance. But still, this is an affordable option when someone wants to cover a large expense without selling their property. Some of the most common reasons the buyer goes for a cash-out refinance include home improvements, buying an investment property, consolidating debt, or paying for school fees.
For instance, if a home is worth $400,000 and the borrower owes $150,000 in this property, it means that the borrower has $250,000 equity in this property. However, this doesn’t mean that the borrower currently has $250,000 in cash or liquid form. To access this cash, the borrower has to use a cash-out refinance option and then use this amount to meet their expenses.
A rate-and-term refinance allows the borrowers to change their current mortgage’s rate, length of the term, or both. This is the most common refinance option in which the borrower replaces the existing loan with a new loan with different rates and terms. The interest rate for this loan changes, which changes the monthly payments too. Conventional loans and government-backed loans such as FHA, USDA, and VA loans are also eligible for a rate-and-term to refinance. To qualify for these loans, the borrower must meet the eligibility requirements, such as their credit score, property equity, and debt-to-income ratio.
The borrower can use a rate-and-term refinance to switch from a conventional loan to an FHA loan or vice versa. They can also switch from an FHA mortgage to another FHA mortgage to get better rates and terms. Rate-and-term financing allows borrowers to save money on interest by reducing monthly payments. The main goal of rate-and-term refinances is to save money. If the borrower refinances to a shorter loan term, the monthly payments will be higher, but the borrower will be able to pay off the loan quickly and save on interest. On the other hand, if the borrower decides to increase the loan term, the monthly payments will reduce, but the total cost of the loan will increase because of added interest for the increased term.
A rate-and-term refinance can also be used to eliminate PMI or mortgage insurance. It is also helpful for moving from a 30-year mortgage to a 20 or 15-year mortgage.
Cash-in refinances the homeowners to pay a lump sum instead of borrowing against their equity. Through this refinancing, the borrower can qualify for small monthly payments or LTV (loan-to-value ratio) by paying off some portion of the loan. A loan-to-value ratio evaluates the lending risk that the lenders carry out before approving a mortgage. An LTV describes the loan amount’s ratio to the asset’s current market value. A cash-in refinance is the opposite of a cash-out refinance. A borrower may take out a cash-in refinance for various purposes; the following are the things to consider:
- To reduce monthly payments, get a better interest rate, eliminate PMI, or have a mortgage balance lower than the home’s market value.
- For refinancing a conventional mortgage. Cash-in refinances are available for conventional loans and are not very common as compared to other refinances.
- The borrower must have at least 20% of the equity in their homes; however, borrowers with a lesser than 20% equity in their homes can also qualify. Besides that, the borrower must have a credit score of at least 620.
A streamline refinance is available for borrowers that have government-backed mortgages such as FHA, VA, or USDA loans. Streamline refinances are a good option for a quick and less complicated refinance. These refinance options don’t require a credit check or appraisal and offer faster turnaround times with low closing costs. Streamline refinances are of two types: credit qualifying and non-credit qualifying refinances. A credit check is required for credit-qualifying refinances. Streamline refinance is a good option if the borrower wants a lower interest rate and wants to save money during the loan term. Popular streamline refinance options include FHA streamline refinance, VA streamline refinances, and USDA streamline refinance.
Example 1: A family bought a house worth $375,000. They paid a 20% down payment and took a mortgage for $300,000 after paying $75,000. The mortgage is a 30-year fixed mortgage at an interest rate of 6%. However, five years later, the family has a better credit score and is eligible for a loan with lower interest rates. They decided to refinance the loan to reduce their monthly payments. For this purpose, they applied for a rate-and-term refinance. At that time, the family still owes $279,000, their existing mortgage balance.
After refinancing the existing mortgage, the family took out a new mortgage at a lower interest rate of 4%. The family can save $492.54 on monthly payments with this new rate-and-term refinance.
Example 2: John owns a property worth $250,000 on which he has an existing mortgage of $150,000. This means that he has $100,000 equity in this property. At this point, he needs to renovate the property, and he needs $50,000 cash. Since he has $100,000 equity in the property, he qualifies for a $50,000 cash-out refinance on this mortgage. Once he takes a cash-out to refinance $50,000, his new mortgage balance increases to $200,000. The following is a breakdown of the cash-out refinance:
- Property value: $250,000
- Existing mortgage balance: $150,000
- Equity: $100,000
- Equity to withdraw: $50,000
- Loan term: 30 years
- Loan-to-value ratio: 80%
- Monthly payment: $1,145.69
Frequently Asked Questions
Why Should One Refinance a Loan?
Refinancing is a good option in several situations. For instance, if the borrower needs to save money by reducing monthly payments, they refinance at a lower interest rate.
Refinancing is also a good option if the borrower needs instant funds; a cash-out can help the borrower against their equity.
Lastly, refinancing is a good option when one wants to switch from a fixed-rate mortgage to an adjustable-rate mortgage or vice versa.
How to Apply for a Refinance?
To apply for a refinance, the borrower must compare the refinance rates and compare different lenders. A competitive rate will allow the borrower to save on upfront and closing costs and monthly payments. The borrower must first assess their situation, which includes knowing credit history and score, income and employment history, equity in the home, home’s current value, and other debt obligations.
After comparing various lenders, the borrower can apply for a refinance by submitting an online application. The borrower will have to submit all the necessary documents according to the lender’s requirements. Once everything is done, the lender will close the loan by signing off the documents. If it’s a cash-out refinance, the borrower will get a pay cheque or wire transfer for the cash amount.
What are the Costs of Mortgage Refinance?
Refinancing can include different fees and charges depending on the lender. For example, there is a mortgage application fee, home appraisal fee, loan origination fee, documents preparation fee, inspection fee, survey fee, and more. The borrower can also use a calculator and input all the fees to calculate the total cost of refinancing a mortgage.
What are the Drawbacks of Refinancing?
Though refinancing is a very useful financial tool, it has a few drawbacks. For example, if the borrower refinances to a longer term to reduce monthly payments, the loan cost total cost will increase as the borrower will have to pay more interest over time.
If the borrower uses cash-out refinance to borrow against their equity, their loan balance will increase because that amount adds to the remaining mortgage balance. Thus, the borrower will have to repay an increased loan amount. Besides that, missed payments can hurt the credit score, and hard inquiries can also damage the credit for a long time.
What to Know for the Real Estate Exams
Refinancing allows the borrower to get a new loan with better rates and terms. Using this financial tool, borrowers can reduce their monthly payments, shorten the loan terms, change the rate type, pay down their balance, and borrow against their equity. If the borrower is planning to stay in their home long-term, it is wise to borrow against equity or extend the loan term to enjoy lower monthly payments.
To get a better refinance rate, the borrower must increase their home’s equity, improve their credit score, and pay the closing costs upfront. To get the best refinance lender, the borrower must compare, shop around, and go through the lender reviews.
If you’re preparing for a real estate exam, there are many other finance real estate terms you must go through to ace the exam.