What Is Refinancing?
The term refinancing refers to the act of replacing an existing loan with a newer one, usually with different interest rates and terms. Refinancing may also change the nature of the loan. An Adjustable Rate Mortgage (ARM) can be replaced by a fixed-rate mortgage.
Different types of loans can be refinanced, including mortgages, personal loans, and auto loans. However, the most commonplace use of the term refinancing is for mortgage loans.
Refinancing can also be used as a debt-consolidation strategy, allowing an individual to combine different, usually costlier debts into a single, more affordable debt.
5 Reasons To Refinance
There are five reasons you may consider refinancing your mortgage or a different loan.
If you have a fixed-rate mortgage or another fixed-rate debt for which the interest rates are locked in and the current rates are significantly lower, it might be a good time to refinance your loan.
It may come with additional costs, and you have to start paying interest on the new debt from scratch (after refinancing), but if the difference in the past interest rate and the current rate is significant enough, refinancing will save you money over the collective life of your debt.
Where you are on your amortization schedule and the market value of the home determines refinancing profitability because it influences how much you have paid towards the principal amount of the existing loan and how much is now available based on the market value. The value factor does not influence auto loans since the value of a vehicle deteriorates over time.
Changing The Loan Term
If your financial condition has improved over the years and you can pay more towards debt than your fixed monthly payments, you have two choices to pay off your loan early.
First, you can create and adhere to a prepayment plan, assuming it doesn’t come with penalties and your lender is accommodating. On the flip side, you can refinance your loan for a different term.
Let’s say you have a 30-year fixed-rate mortgage. At some point it may be in your interest to refinance to a shorter term which may increase your payment, but reduce the amount of interest that you pay over the life of the loan.
Changing The Loan Type
The most common loan type change through refinancing is from an adjustable-rate mortgage or ARM to a fixed-rate mortgage. This makes your new debt more predictable by preventing future interest rate hikes.
Leveraging Equity (Cash Out Refinancing)
A common reason to refinance is to take out equity from your home. How much equity you have built over time depends upon a number of factors, including the amortization period. The shorter the amortization period, the quicker you might build equity. Value appreciation is another important factor.
The reasons to take out equity may vary. You may use it to meet a major expense or for home improvement. Regardless of the reason, taking out equity from your home instead of taking on new debt may be a financially sound decision, especially if you can refinance at a better rate.
If you have multiple debts, you may consider consolidating them into one by using refinancing. For example, let’s say you are paying off an auto loan, have a long-term student loan, credit card debt, and a mortgage. The different loans may have different interest rates, and some may accumulate interest faster than others, increasing the overall size of your debt.
If you can take out equity from your home (cash out refinancing) and use the sum to settle your other debts, you will only be left with one – the mortgage. This will consolidate all your debt into one.
Factors That Impact Refinancing
A few factors that have a significant impact on refinancing are:
Ideally, you should refinance only when the interest rates are around the same or lower than what you are currently paying. It may not always be a viable option, but refinancing to a higher rate can significantly increase the overall cost of your debt and should only be considered if the alternative is even more financially destructive, like taking on new debt at a higher interest rate.
Your credit score can have a significant impact on the interest rates you get for a loan. A poor credit score can increase the interest rates you get by as much as 1.5%. If it falls below a threshold, you may not even qualify for a loan or refinancing, and even if you do, the terms and interest rates may be significantly more stringent, eroding many of the benefits of refinancing.
A credit score can even augment or reduce the benefits of refinancing. If you want to refinance your property when the interest rates are lower than your current rate and your credit score is better than what it was when you took out the original loan, you will maximize the benefits of refinancing.
This will take into account the current market value of the home, including any upgrades that you may have made. It will determine how much equity you now have in the home and the amount available for you to borrow. Your monthly mortgage cost will be determined by the interest rate available, the amount of money borrowed, and the term of the loan.
It may be higher or lower than your initial payment depending on whether your goal is to pay off the mortgage faster or take money out for things like home improvements or to pay for your child’s education. That is one of the features of owning a home, if you need some of the equity stored in the home, it can be borrowed and used if needed.
Different lenders have different fees associated with refinancing, different protocols, and their own characteristic rules for refinancing. Choosing the right lender can keep your cost of refinancing to a minimum and make the process easier and smoother for you.
Your amortization period can have a significant impact on your refinancing. Let’s say you have a 30-year fixed-rate mortgage on a $500,000 property for which you put 20% down and locked in a 6% interest rate. After five years, you would have paid over $116,000 in interest and only about $28,000 in principal. Compared to the same loan with a 20 year amortization schedule, after five years you would have paid $111,542 in interest and $60,402 in principal.
Assuming the home’s value hasn’t changed in the five years, once the costs of the transaction are taken into account the interest rate may have to be significantly lower than 6% for refinancing to be worth it.
How To Refinance Your Loan
If you understand all the factors that impact refinancing, the first step is to ask why? If you are not refinancing for a specific goal, like taking out equity from your property, then the ideal scenario should be multiple positive factors aligning in your favor.
The most important factors to consider are the current interest rate, your credit score, and the equity you have built up on your property.
It’s also a good idea to assess the value of the loan over the entire repayment period, before and after refinancing. Once you are sure that the numbers are in your favor, you should:
- Set clear refinancing goals and determine what loan terms you want in your refinanced loan.
- Calculate the target monthly mortgage payments and ensure that they are affordable.
- Talk to your current mortgage lender and a few others to get the best terms and rates. Working with your existing lender may make the process smoother.
- Determine if you want cash out or not.
- Finalize the terms and prepare for an official appraisal.
The process may differ for different homeowners, but it’s important that you run the numbers or at least understand all the numbers to determine that you are making an educated financial decision when refinancing.