Last Updated on May 28, 2017 by Andrew Lee
The process of refinancing involves swapping your current housing loan with a new one. When you accept a mortgage refinance offer, you’ll pay off your existing loan and start a new one. Many homeowners choose to do this for a variety of reasons although the primary one is to secure a better term and interest rate.
There are several mortgage refinancing options you can choose from, and it’s important you base your decision not just on your current financial capabilities but your future housing needs and repayment strength too. Understanding their differences will minimize your risks of committing costly refinancing mistakes.
Reasons to refinance
The first step to creating a well-designed and financially-sound refinance mortgage plan is to have a good reason to do so. There are certain situations wherein paying off your original housing loan in exchange for signing a contract for a new one makes sense.
One of these is to secure a loan with a lower interest rate. In many cases, as homeowners work their way up the professional ladder, most of them earn bigger money, allowing them to meet their financial responsibilities on a timely manner. This then leads to improved credit score and rating, which gives them the opportunity to secure loans with lower interest rates. This applies to mortgages too, as well as refinancing. When you refinance at the right time and for the right reason, you can potentially save hundreds, even thousands of dollars every year.
Another reason to refinance is to have the ability to make larger purchases (such as the case with car buying) or to pay off their other debts, such as credit card bills. Refinancing allows them to take equity out of their home, which gives them the financial ability to do such things.
Many other consumers in the United States opt to have their current housing loans refinanced so that they can live a mortgage-free life sooner. You can choose to do this once you’ve had a considerable increase in income, which allows you to make bigger payments towards the repayment of your home loan.
Rate-and-term or “traditional” refinancing
Also known as “traditional” refinance, rate-and-term refinance comes with the simplest and easiest-to-understand process. With this, you only change the loan’s term, its interest rate or both, but not the amount. Note that the loan term refers to the length of your home loan, so in the case of a 30-year fixed-rate mortgage, the term is 30 years.
With this, you can have your 30-year fixed rate mortgage refinanced into a 15-year fixed rate mortgage with the same 6% rate; or exchange it for a 30-year fixed rate loan with a loan of the same term, but at a lower rate of 4.5%.
It’s important you check and compare refinance mortgage rates to make certain you can really save money and not just extend your repayment period. This type of refinancing option makes sense if you can save cash even after paying the closing costs.
Another attractive feature of traditional refinancing is that it doesn’t allow adding of the closing costs to the loan balance. This means you don’t have to worry about out-of-pocket expenses, aside from having some left-over cash after closing.
Homeowners who refinance mortgage loans through the cash-out method also enjoy either a lower interest rate or a shorter term. The main difference between this and traditional refinancing lies in the amount of money you borrow: the former allows you to take out a new loan with a balance greater than the current balance of your original loan. In most cases, the excess amounts to five per cent of greater.
Since you only have to pay back your original loan to the lender, you can use the excess for a number of things. One is to pay the closing costs. You may also use the extra cash for debt consolidation purposes.
Keep in mind though, that this refinancing method is riskier than rate-and-term; thus, lending institutions offering this service require borrowers to meet stricter, more rigorous requirements. In addition, most cash-out refinance programs have a “cash out” limit of $250,000.
As you shop around for mortgage refinance rates, you most likely will encounter the term “cash-in refinance.” These are essentially the exact opposite of the cash-out method.
Opt for this, and you would have to pay cash to cover your closing costs, which then pays off your existing loan balance, as well as the amount you still owe your lender.
Because cash-in mortgage refinance results in the same benefits as the other two (lower mortgage rate, shortened loan term or both), it leaves a lot of homeowners confused. There are several reasons you may want to choose this over your two other options, including the following:
- Get a mortgage rate reduction available only to certain borrowers.
Some lenders offer a mortgage rate reduction only at lower loan-to-values. If this is your only option to bring your rate down, then you may want to consider going for this refinance method.
- Eliminate mortgage insurance premium payments.
If you’re looking to cancel your mortgage insurance premium (MIP) payments, then a cash-in refinance may offer you a good value. Paying down a conventional mortgage to 80% LTV or lower will result in the cancellation of your mortgage insurance premiums.
The bottom line
Regardless of economic climate and real estate market performance, most borrowers still encounter some difficulties making repayments toward their mortgage. Between an unstable economy and high interest rates, you may have a tougher time meeting all your financial responsibilities. In the event that you find yourself in such a situation, you should already consider refinancing, and figure out whether or not it can help strengthen and reinforce your finances.
Be careful though, as a slight error on your judgement can lead to refinancing doing you more bad than good. However, as long as you explore all your options, compare mortgage refinance rates and enter its world educated and knowledgeable, you can benefit greatly from this loan exchange process.