While it is not the best time to refinance due to rising interest rates, you might still consider refinancing if you want to tap into your home’s equity. If you’re considering refinancing your mortgage, here’s how it works and what options are available to you.
When you opt for a mortgage refinance, you replace your current mortgage with a new loan. The new loan might have different terms, moving from a 30-year to a 15-year term or an adjustable rate to a fixed rate, for instance, but the most common change is a lower interest rate. Refinancing can allow you to lower your monthly payment, save money on interest over the life of your loan, pay your mortgage sooner and draw from your home’s equity if you need cash for any purpose.
Similar to when you first applied for your mortgage, a lender will review your finances to assess your level of risk and determine your eligibility for the most favorable interest rate. It is an entirely new loan, and it could be with a different lender.
Your new loan might also reset the repayment clock. For example, if you have made five years of payments on your current 30-year mortgage, that means you have 25 years left on the loan. If you refinance your loan to a new 30-year term, you will restart the payment clock and will have 30 years to repay the loan. However, if you refinance your loan to a 20-year term, you will be able to pay off the loan five years earlier.
Be aware that refinancing comes with closing costs, which can affect whether getting a new mortgage makes financial sense for you. These costs can be between 2-5% of the amount you refinance. Common closing costs in close discount points, an origination fee, and an appraisal fee. You will need to calculate the break-even point to determine whether you will stay in your home long enough to recoup the closing costs and benefit from the savings of the refinance.
Before we delve into the benefits, it is important to know what options are available to you when you refinance your mortgage. Be sure to check with your financial institution if these types of refinancing are offered.
Rate-and-term refinances – This is a basic form of refinancing that changes either the interest rate of the loan, the term of the loan, or both. This can reduce your monthly payment or help save you money on interest. The amount you owe generally will not change unless you roll come closing costs into the new loan.
Cash-out refinances – When you do a cash-out refinance, you are using your home to take cash out to spend. This increases your mortgage debt but gives you money that you can invest or use to fund a goal. Further, you can also secure a new term and interest rate during a cash-out refinance.
Cash-in refinances -With a cash-in refinance, you make a lump sum payment in order to reduce your loan-to-value ratio, which cuts your overall debt burden, and potentially lowers your monthly payment. This could also help if you qualify for a lower interest rate. Prior to making a cash-in refinance, you will want to evaluate whether paying the lump sum would deprive you of more lucrative opportunities or needlessly drain you of your savings.
No-closing-cost refinance – A no-closing-cost refinance allows you to refinance without paying closing costs upfront; instead, you roll those expenses into the loan, which will mean a higher monthly payment and likely a higher interest rate. A no-closing-cost refinance makes the most sense if you plan to stay in your home short-term.
Short Refinance – If you are struggling to make your mortgage payments and are at risk of foreclosure, your lender might offer you a new loan lower than the original amount borrowed and forgive the difference. While a short refinance spares the borrower the financial impacts of a foreclosure, this option comes at the expense of a hit to your credit score.
Reverse mortgages – If you are a homeowner, aged 62 or older, you might be eligible for a reverse mortgage that allows you to withdraw your home’s equity and receive monthly payments from your lender. You can use these funds as retirement income, to pay medical bills, or for any other goal. You will not need to repay the lender until you leave the home, and while the income is tax-free, it will accrue interest.
Debt consolidation refinances – Similar to cash-out refinances, debt consolidation refinances give you cash with one key difference: you use the cash from the equity you have built in your home to repay other non-mortgage debt, like credit card debt. Your mortgage will increase, but because mortgage rates are usually lower than other forms of debt, this can save you money in the long run. Plus you might be able to take advantage of the mortgage interest deduction.
Streamline Refinance – This type of refinancing accelerates the process for borrowers by eliminating some of the requirements of a typical refinance, such as a credit check or appraisal.
With all these options at your disposal, it is easy to see why some would consider a mortgage refinance, as one can lower their interest rates, lower their mortgage payment, can decrease their term, and pay off the mortgage sooner, they could tap into the home’s equity and take cash out at closing, they could consolidate debt, change their rate, and might be able to cancel private mortgage insurance premiums to avoid paying unnecessary fees.
Be aware they are some downsides, as you will have to pay closing costs, you might have a longer loan term, you could have less equity in your home if you take cash out, and you might need to deal with borrower’s remorse if rates drop substantially after you close, and your credit score will take a temporary hit.
Refinancing can be one of the best financial decisions you make. If you’re planning to continue living in your home for a long time, lowering your interest rate by more than half a percentage point can make a huge difference in your budget.
