How does mortgage refinancing work?

What is mortgage refinancing? How does it work? If you have bought a home, you have probably applied for a mortgage from your bank. The process of refinancing a mortgage is no different than applying for a mortgage in the first place.

So, what is refinancing? Refinancing is a term used when an existing credit agreement is revised. It happens when the individual is looking for a favorable term to their loan agreement.

It occurs when the terms set, interest rate, payment period, and other terms are revised.

Mortgage refinancing is where an individual takes a new loan to pay off the original mortgage. Homeowners in most cases refinance their loan to take advantage of the reduction of market interest rates, reduce their monthly loan repayment with a longer repayment term, and convert a portion of their equity.  

However, before embarking on this process, it’s important to know the benefits, how mortgage refinancing works, the reasons for refinancing a mortgage, and the different types of refinancing.

So, let’s delve in!

How does mortgage refinancing work?

The process of mortgage refinancing is somewhat similar to how you got the first mortgage. The lender will evaluate your finances, determine your risk, and the favorable interest rate you are eligible for because this is a new loan you’re taking. If your credit score has improved from when you took the first loan, you qualify for a better interest rate.

Refinancing your mortgage may be done with another lender other than the one you had initially used. It’s also important to note that refinancing has closing costs.

Reasons for refinancing

Here are some reasons why it works to your advantage to refinance your mortgage.

  • Lower interest rate and payment – This is one of the common reasons why people refinance their loans. Your access to lower interest rates helps you save lots of money over the duration of the loan if your credit score has improved since you first got your first mortgage or the market rates have lowered.
  • Explore mortgage options that work best for you – Because this is a new loan you’re taking; you get to choose mortgage type. For example, when you first applied for a mortgage, you chose one with an adjustable-rate mortgage and you want to change its uncertainty with a fixed mortgage rate. Refinancing allows you to explore different mortgage options to discover which works best for you.
  • Shorten loan term – If you shorten your loan term from 30 to 25 years, you can qualify for a lower interest rate. Also, shortening the loan term helps you save money on interest over the lifetime of the loan.
  • Cash-out – This happens when you have accumulated equity in your home, with refinancing, you can cash out some of that equity to pay your bills and any other purpose you may want to use the finances for. Home equity is the amount of your home that is free from the remaining balance of your mortgage. You accumulate equity through the monthly mortgage payments made.

As you examine the reasons for refinancing, some of the pitfalls include:

  • Lengthening the mortgage term can result in an increase in the interest rate.
  • There is no set guarantee of better terms from the new loan.
  • Although your credit score may have improved, you may not get a lower interest rate if the market rates have increased from when you acquired your first loan.
  • Payment of closing costs.
  • Cashing out on equity results in a higher loan amount which could increase your monthly payment.
Types of mortgage refinancing
Rate-and-Term Refinance Loan

The goal of this type of mortgage refinancing is to change the interest rate and loan term without affecting the loan amount.

It works best if you’re trying to save on your monthly payments or if you’re trying to change your loan rate from an adjustable-rate mortgage to a fixed rate.

Cash-Out Refinance Loan

As the name suggests, this loan type is where one cashes out a portion of their home equity to take out cash to spend.

Although the homeowner gets extra money for investment or funding a project, it usually results in a higher loan amount and an increased interest rate.

Cash-In Refinance Loan

Here is where one pays a lump sum amount of money to reduce their loan. This tremendously cuts the loan burden and could help you qualify for lower interest rates. However, before paying the lump-sum amount, it’s important to evaluate whether doing so will deprive you of more worthwhile opportunities.

No-closing-cost refinance

No-closing-cost refinance allows the homeowner to refinance without paying the closing costs upfront. Instead, the costs are put together with the loan amount.

This results in a higher monthly payment and a likely interest rate increment. This type of refinancing works best when you’re staying in the house for a short duration and plan to use the house for investment purposes.

Short refinance

If you’re struggling in paying your mortgage and are at risk of foreclosure, the lender might offer you a loan lower than the original amount and forgive the difference.

Although short refinancing curbs the individuals from the financial impact of a foreclosure, it affects your credit score.

Conclusion

Refinancing is one of the best financial decisions you can make. A chance to lower your interest rate, shorten the loan term, and help you in your mortgage repayment.

Although refinancing has its pitfalls, the advantages far outweigh the pitfalls. Before refinancing your mortgage, consult with your lender or a financial consultant. Be sure to check which type of refinancing works best for you and make the investment.

For further clarity, please feel free to consult with us.  

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