The 30-year fixed mortgage rate has risen beyond 4%, marking the end of the historically low rates seen in 2020. Even if you don’t need to get cash out of your house, learning how to refinance your mortgage could be helpful if you have an existing mortgage with a higher interest rate, wish to extend or decrease your repayment period, or need to make other changes to your mortgage.
However, even seasoned homeowners may become frustrated by the numerous moving pieces and unfamiliar terminology of the mortgage refinance process. To save you time and effort, let’s review the fundamentals of mortgage refinancing before you start.
What exactly is refinancing?
Refinancing is replacing one mortgage with another and using the proceeds to pay off the original loan. Most borrowers decide to refinance to take advantage of a new loan’s lower interest rate. Still, other motivations may include changing mortgage providers, modifying the loan’s terms, or eliminating the need for PMI (private mortgage insurance). You can use the money you receive from a mortgage refinancing for anything from home repairs and renovations to purchasing another property or settling outstanding consumer debt.
Refinancing is pretty similar to the mortgage application procedure. It would be best to talk to a financial institution, such as a bank, credit union, or mortgage broker, about your alternatives, which may involve getting a new loan and the associated fees. When you use an online service like LendingTree, the service will automatically contact various lenders on your behalf, allowing you to compare your options quickly and easily.
Refinancing glossary
Before refinancing your mortgage, you should familiarize yourself with various terms and phrases. There are several important factors to consider while deciding whether to refinance.
What follows is a definition and explanation of some of the more common phrases used in refinancing.
Annual percentage rate (APR)
This is what a borrower will pay for a loan. Unlike the interest rate, it factors in the lender’s fees and the interest owed. Once again, a lower percentage is preferable.
Interest rate
The annual percentage rate (APR) is the sum of money your bank or credit union will charge you for the privilege of lending you money for your mortgage. A percentage (3%, 4.25%, or 5.76%) is used to describe the amount. A lower interest rate means reduced interest payments. A mortgage rate lock can be obtained at the start of the refinancing process and ensures that the borrower can lock in the current interest rate on the new mortgage throughout the duration of the transaction.
Suppose market interest rates drop while you’re refinancing. In that case, you may be able to remove your rate lock and re-lock at a lesser percentage if you pay an additional fee for a “float down rate option.”
Adjustable-rate mortgage (ARM)
Modified adjustable-rate mortgages (ARMs) are loans with interest rates that are locked in for an initial period of time but then allowed to float. In the mortgage industry, terms like “3/1 ARM” and “10/1 ARM” refer to these adjustable-rate mortgages. The first figure represents the number of years over which the rate will remain unchanged. After that first fixed amount of time has expired, the second number indicates how frequently the interest rate can be changed, also expressed in years.
The interest rate on a 5/1 ARM mortgage is fixed for the initial five years but is subject to annual adjustments. Depending on the state of the economy, rates may be adjusted upwards or downwards following a publicly available reference rate, like the prime rate.
Fixed-rate mortgage
A fixed-rate mortgage is a loan whose interest rate remains constant throughout the loan’s term. The interest rate on a mortgage with a period of 15 or 30 years is virtually always fixed.
Closing
This is the final phase of refinancing. At this point, you’ll sign the final mortgage documentation, officially assuming your new mortgage’s responsibilities. Your lending institution will send payment to your current mortgage servicer.
Closing costs
You have to spend closing costs to complete a mortgage, whether it’s a purchase or a refinance. The mortgage financing appraisal fee covers the expense to the lender of using an appraiser to establish the value of your house. In contrast, the origination fee is the amount lenders demand to complete and underwrite a mortgage.
Lenders may advertise “no closing costs” refinance options, but the reality is that you’ll pay a far higher interest rate. Your lender must provide a closing disclosure detailing its closing fees no later than three business days before closing.
Points
You can reduce your interest rate and, thus, your monthly payment by paying these fees to your lender. It’s common practice to pay one point, or 1% of the loan’s principal, to lower the interest rate by 0.25%. With a $2,000 down payment and 2 points, your new interest rate on a $200,000 mortgage refinance would be 3.75% instead of the standard 4.25%.
Cash out refinance
It’s possible to refinance your mortgage for an amount greater than what you owe and keep the difference as cash. Although you will have less home equity, you can use the money for repairs, debt, and other requirements. A rate-and-term refinance is the polar opposite of a cash-out refinance, as it allows you to adjust your mortgage’s interest rate and/or term without tapping into your equity.
Private mortgage insurance (PMI)
If you don’t have cash on hand to cover 20% of the home’s price when you make your down payment, your lender will likely obligate you to pay for private mortgage insurance (PMI). This is due to the higher risk involved for the lender if the mortgage doesn’t cover the entire purchase price (at least 80%). Personal Mortgage Insurance (PMI) is an additional, non-refundable expense.
It’s important to distinguish between private mortgage insurance and the insurance required for mortgages guaranteed by the Federal Housing Administration (FHA). Unlike PMI, which only applies to borrowers with less than 20% equity, the FHA mandates advance and annual insurance payments. First-time homebuyers favor FHA loans because they are more accessible.
Equity
The difference between the current market value of your home and the amount owed to your lender. This is the proportion of your house that you own outright. For example, if you owe $175,000 on your mortgage but your property is worth roughly $300,000, your equity is $125,000.
Prepayment penalty
If you complete your mortgage loan before the end of the loan’s term or before you’ve paid off a particular percentage of the principal, you may be subject to a prepayment penalty. If your current mortgage has a prepayment penalty, you should factor that extra expense into your decision to refinance.
Should you use a mortgage calculator?
You can easily find a free online refinance calculator to assist you in figuring out if it will be worthwhile to refinance your mortgage. Simply plug in your current mortgage information, new mortgage details, and any costs associated with the refinancing, and the calculator will do the rest.
A refinance calculator can help you determine whether or not the savings from a new mortgage will be worth the expenditures involved.
Why should one consider refinancing?
Many people benefit from refinancing, although their specific advantages will change depending on their circumstances and objectives. Of the many potential advantages, cost reduction is usually at the top of the list.
If you want to refinance your mortgage, you may be able to eliminate mortgage insurance (if you borrow less than 80% of your home’s value) or remove a cosigner from your loan in exchange for a lower interest rate, lower monthly payments, a shorter loan term, faster equity buildup, debt consolidation, etc.
What risks are involved with refinancing?
Although refinancing often makes financial sense, not everyone should do it. You should always do the numbers to ensure success in a business deal.
When you refinance, you typically have to pay some fees. You can generally roll these expenses into your new loan, albeit doing so will increase your regular payments. To ensure the additional savings from a refinance outweigh the expenditures, you should learn as much as possible about these fees and factor them into your decision.
Use a mortgage refinancing calculator to determine the “break-even” point or the point at which your monthly savings from the new mortgage are equal to its closing expenses.
Suppose the break-even threshold on your new mortgage is seven years, but you only intend to stay in your home for another five years. Refinancing may be more costly than remaining on your current mortgage, even though the interest rate is higher.
The new mortgage term is something else to think about. Paying more toward interest than principal in the early years of a mortgage is standard practice. This means that, similar to the first few years of your original mortgage, the most significant interest payment will be due at the outset of your new mortgage if you decide to refinance.
If you’re halfway through your 30-year mortgage and then restructure into the next 30-year one, you’ll pay interest on your loan for 45 years. The total interest you pay after refinancing will likely be higher, even though your monthly costs are lower.
When refinancing, you should choose a shorter term if you are more than ten years into a 30-year mortgage. By choosing a mortgage term of 15 or 20 years, you can avoid paying much of the interest in the long run.
What role does a borrower’s credit score have in determining their ability to refinance?
Refinancing requires a good credit score, and you will have to pay a higher interest rate when you have a low credit score.
For instance, if your credit score is below 700 and your friends’ is above 700, the price difference could be half a percentage point. Additional monthly payments of around $55 could be expected on a mortgage of $190,000 over a period of 30 years. The difference is substantial over 30 years, adding to over $20,000.
Suppose you’re planning on refinancing your home soon. In that case, it’s essential to keep your current credit obligations and avoid making any decisions that could temporarily lower your score, such as getting a new vehicle loan or opening a bunch of new credit card accounts.
Final words
A solid understanding of the fundamentals is essential if you want to make an informed decision about whether or not to refinance. You should consider the current loan rates, closing fees, and your personal condition and financial goals.
You shouldn’t refinance if, for example, you plan to relocate within the next few years and won’t be in the house long enough for the savings from your new mortgage to outweigh the price of the refinancing itself. However, if you plan to remain in your home for the foreseeable future and can refinance at a rate at least one percentage point lower than your current mortgage, doing so could save you money in the long run.
If a refinance makes financial sense after utilizing a refinance calculator, look around for the lowest mortgage refinance rates and fees. If you want to swiftly compare refinancing conditions among several lenders, using a web-based comparison tool is the way to go.
You can save money and get closer to your financial goals by refinancing your mortgage once you’ve made that decision.
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