Mortgage Refinancing

Mortgage refinancing occurs when a prior mortgage debt is replaced with a new debt under different terms. Homeowners do this to either to benefit from a lower interest rate, reduce the rate of monthly repayment, to modify the risk, or to get cash on home equity. Sometimes, refinancing is done under financial distress, and this is known as debt restructuring.

There are several reasons to consider refinancing a home mortgage. Because monthly payments are tied to the mortgage interest rate, lower rates often mean lower payments. Rates can improve either through market conditions or because a borrower’s credit score has gotten better. Another benefit of lower interest rates allows homeowners to build equity on their home.

Changing the length of the mortgage is another reason to refinance. Increasing the mortgage term reduces the amount of payment every month, but this also increases the term of repayments. Subsequently, more money is paid toward interest. Mortgages that are short-term usually have lower interest rates and the loan is paid off faster. However, payments can be significantly higher because more of the principal is getting paid every month.

Modifying the risk means changing from an adjustable-rate mortgage to a fixed-rate mortgage. With the former, also known as ARM, monthly payments fluctuate along with the interest rate. Some borrowers might feel uncomfortable with seeing their payments change, which can prompt the switch to a fixed-rate loan. Also, if there’s a chance that interest rates could increase, a change to a fixed-rate might be a better option.

The borrower can also choose to collect a cash payment, or equity, the dollar-value difference between the property’s value and the amount owed on the mortgage. This is also called cash-out refinancing. When equity is taken, less of the home is owned, meaning if the home is sold, there will not be as much profit made after the sale. While the money can be used for whatever the borrower wants, most financial advisers suggest not taking equity to pay off credit cards or car loans.

Eligibility is determined by several factors, including income and assets, other debts, credit score, the property’s current value (determined from an appraisal), and the loan amount requested. If the loan-to-value (LTV) ratio is acceptable according to the lender’s guidelines, they will most likely approve the loan.

However, if housing prices drop, the mortgage may be worth more than the home or in some cases where loans have negative amortization, or when the monthly payment is less than the interest owed, it may be difficult for homeowners to refinance.

Fees to refinance vary, but it’s typical to pay about 3 to 6 percent of the outstanding principal balance, in addition to prepayment penalties or other costs.

When thinking about mortgage refinancing, it’s important to ask questions and understand all of the fine print in order to make the right financial decision.