A Complete Guide to Mortgage Refinancing
You have gone through the stress of buying a home, the chaos of moving, and the difficulties that those first few years can bring. You’re a homeowner now and you’re looking forward to years of monthly payments, home equity growth, and, if all goes well, one of the best investments you will ever make.
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But the story isn’t over just yet and with refinancing, you could get a lower interest rate on a new mortgage loan, potentially reducing your monthly mortgage payment and paying less money over the life of the loan.
Mortgage Refinance Options
A mortgage refinance essentially swaps your existing mortgage for a new mortgage, creating lower monthly payments without the need for an upfront payment or other expenses. But it can also increase/decrease the term or swap a fixed-rate mortgage for an adjustable-rate mortgage.
To make sure we cover all bases, we’re grouping home equity loan options into this category, as they also revolve around your mortgage and allow you to benefit from the payments you have made over the years.
All the following options are available to homeowners and can provide a low rate loan or change the terms of an existing mortgage:
A term loan is one of the best options for refinancing your home loan, providing it is used to reduce the term. This can greatly reduce the amount of money you repay over the term of the loan, but it will also increase your monthly payment.
If you take out a 30-year, $200,000 mortgage with a 4% interest rate, you’ll be expected to repay $386,000 over the term. If you drop this to 15 years, you’ll pay over $100,000 less, which is a huge difference and makes that house a more worthwhile investment.
Of course, this applies at the commencement of the loan, when those changes are going to have the biggest impact, but you can also greatly reduce the balance by switching at a later date.
The most common type of mortgage refinance is one aimed at changing mortgage rates, swapping a higher interest rate for a more respectable and manageable rate. You can get a lower rate if your circumstances have improved and mortgage rates have dropped nationwide.
However, if rates are high and you haven’t done much to improve your credit report and credit score, you may struggle to find mortgage lenders willing to give you the rate you seek.
A cash-out refinance mortgage swaps your current loan for a newer, larger loan and then gives you the remainder as a cash sum. These mortgages generally increase your payments and give you worse terms, but in exchange, you’ll get a large cash sum you can use to improve your home or go on vacation.
The opposite of a cash-out mortgage, a cash-in mortgage is designed to reduce your equity by putting money into your mortgage. If you have a cash windfall, for instance, such as a lottery win or an inheritance, you can use that money to repay some of your mortgage, thus reducing the balance/term and potentially saving you thousands of dollars.
Many homeowners see this as waste, because they only focus on the large sum leaving their account when only a small amount is needed. It’s hard to spend $20,000 when the recipient is only asking for $1,000. Rarely do they realize just how much of an impact that $20,000 could have, potentially saving them another $20,000 in interest payments over the term.
A reverse mortgage is one of the best ways to cash out the equity in your home, but it’s only offered to homeowners above the age of 62 and you need to own most of your home to be accepted.
With a reverse mortgage, you can get a cash sum in exchange for home equity and you don’t have to repay anything until you die or sell the home. However, there are some strict requirements, including the fact the home needs to be your primary residence and should be kept in good condition throughout.
You may want to reconsider this option if you plan to leave your home to your heirs and want to give them as much as possible, but if you don’t have heirs or beneficiaries or you simply want to swap some of your hard-fought equity for a cash sum, it could be ideal.
Do You Pay Closing Costs for Refinance?
You will still need to pay closing costs when you refinance your home loan, even if you paid these the first time around. These costs are not fixed to the house that you buy and are actually charged for the loan you acquire, so every time you take out a new loan, you need to pay closing costs, which can include an origination fee.
However, you get to choose how these are paid. For instance, if you chose to pay the closing costs upfront during your first home loan but don’t have the money or desire to do this the second time around, you can just roll the costs into your monthly payment.
You’ll also need to continue paying property taxes and, if your equity is low enough, private mortgage insurance (PMI).
Home Equity Loan
Once you build equity in your home, you can consider a home equity loan, whereby you use that equity as collateral against a new loan. It’s not a mortgage as such, but if you fail to make the monthly payments you could lose the house.
A home equity loan is basically just a large personal loan you can use for any purpose you wish, the most common of which include home improvements, debt payoff, and even vacations. Because it’s secured against the home, as opposed to an unsecured loan, which isn’t backed by any asset, the lender can afford to offer you low rates and high sums.
You will have an additional monthly payment to make as you now have a loan to worry about, but a home equity loan is nearly always a better option than a large personal loan in terms of everything from the loan origination fee to the monthly payments and more.
You generally need at least 20% equity in your home to apply for one of these loans. The size of the loan is dependent on a number of factors, but mostly revolves around the value of your home.
Home Equity Line of Credit
Also known by the abbreviation, HELOC, a home equity line of credit works a lot like a home equity loan, only instead of getting a single lump sum loan, you’re given a large line of credit.
Generally, there are two stages to a HELOC. During the first, you spend the money as needed, taking as much as you want in the knowledge that every dollar is backed by your home. Once this period ends, you’ll enter a repayment phase where you need to pay back the money you have borrowed.
In many ways, it’s like a credit card billing cycle, only it’s not recurring, and the phases last a lot longer than 30 days.
When to Consider Refinancing Options
All homeowners can consider a mortgage refinance at some point in their journey, but it’s more suitable to those who:
- Have accumulated a lot of home equity and;
- need to repay debts (credit card debt, student loans)
- want to make home improvements
- have an education to pay for
- want to enjoy a vacation
- Have improved their financial situation and want to;
- reduce interest payments
- reduce the mortgage term
- payoff the mortgage quicker
- Need a quick cash injection
- Have financial issues and want to;
- reduce monthly payments
- improve debt-to-income ratio
It’s important to consider the pros and the cons, to look at the ways refinancing can help your situation, as well as hinder it. For example, a reduced term may allow you to greatly reduce the loan term, but it will also increase your liability, which means the risk of missed/late payments is higher and there is a greater chance of defaulting.
Just because you can cover the additional costs now doesn’t mean that will continue for the next few years. What happens if you lose your job or fall ill? Do you have an emergency fund large enough to cover you; will your savings account help out or will you be forced to consider more mortgage refinancing and potentially undo all your hard work?
Home equity loans and cash-out refinancing should also be considered very carefully.
Your house is the most valuable asset that you have; it’s attached to a loan that will stay with you for many years, if not decades. The day you repay the balance of your mortgage in full is a great day, one that greatly improves your net worth as you’ve just cleared a massive loan amount, thus reducing your outgoings, increasing your debt-to-income ratio, and giving yourself 100% ownership of a massive asset.
Imagine that you take out your original mortgage when you’re 30 and you opt for a 30-year mortgage. You plan for your retirement, realize you’ll have all that equity to use when you’re 60, and can start enjoying yourself.
At 45, just as the payments reach a point when you’re covering more of the principal than the interest, you refinance and extend your loan by 10 years in exchange for a cash sum.
How angry will you be with yourself when you reach 60 and realize that instead of repaying the loan balance in full, you now have 10 years left and will pay tens of thousands more in interest?
Summary: Refinance and Monthly Savings
Refinancing isn’t the only way to shave a few dollars off your monthly mortgage payment. Whether you have a 30-year loan or a 15-year loan, if you want to reduce your expenses and quickly build equity on an existing mortgage, keep the following tips in mind:
Double Your Monthly Payments on your Current Loan
Paying more money every month is the easiest way to pay off your mortgage quickly and it’s something you can do without a refinance. Just increase your monthly payments by as much as you can for every month that you can.
However, don’t leave yourself short. By all means, put some more of your disposable income towards your mortgage payments if you can afford it, and during those slow months, when things aren’t going your way, reign it in and take a break.
If you don’t have the money to make these extra payments every month, consider halving your monthly payment and paying one half every 2 weeks. This may seem like a pointless endeavor that achieves exactly the same result, but that’s actually the whole point.
There are 12 months in a year, which means you’ll make 12 payments. But there are 52 weeks and if you break down those weeks down into 4-week billing cycles you’ll make 13 full payments.
If you haven’t figured it out already, it’s because many months have 30 or 31 days, but there are only 28 days in every 4-week period, with all those extra days essentially creating an extra billing cycle. It’s a psychological trick that makes you feel like you’re not paying any extra but ensures you make 1 full extra payment every year.
Act Like you Refinanced
You don’t need to refinance to get the benefits of a shorter loan term. If, for whatever reason, you can’t refinance your home into a reduce term, just act like you did.
Use a refinance calculator to determine how much a 15-year term will cost you and then start paying that extra money every month. If it would cost you $1,500 and you’re currently paying $1,000, give the lender an additional $500 every month. This will ensure that more money goes towards the loan balance, reducing the term and costing you much less over the life of the loan.
This is something you should consider doing if you’re planning to refinance. It will prove you can afford to make those payments every month and are not overestimating your affordability, as so many homeowners do.
Finally, one of the best ways to use the equity in your home is to move into a smaller house and get a second mortgage on a different home or buy it outright. For instance, imagine that you have 50% equity in a home that you bought for $200,000 and is now worth $300,000.
You can sell that house and give yourself $150,000 to play with. Using that money, you could either get a 50% mortgage with some very low and favorable rates, before using the rest of the money to renovate or invest or buy a $150,000 house outright.
That way, you move into a smaller home but swap 50% real estate ownership for 100% ownership, and in the case of the latter, you won’t have any mortgage payments to make, which will save you money every month and give you more options for future mortgages and loans.