Refinancing a mortgage involves paying off the existing mortgage, and replacing it with a new loan. In some cases, it is even possible to combine a first mortgage and a second mortgage into a new loan. There are several reasons homeowners refinance, including taking advantage of falling interest rates, switching into a different type of mortgage and getting cash out from equity in the home.
For borrowers with excellent credit, refinancing can be an excellent way to convert a variable interest rate into a fixed rate loan, or to obtain a lower rate. However borrowers with poor credit and too much debt, may be taking on more risk by refinancing.
Regardless of the amount of equity in the home, the main advantage of refinancing is reducing the loan's interest rate. This benefit is typically available to borrowers who have excellent credit and qualify for lower rates. Obtaining a lower interest rate can have a significant effect on monthly mortgage payments, potentially saving hundreds or thousands each year.
Many people also choose to refinance to take cash out of the home's equity for a large purchase or reducing credit card debt. Cash out refinances usually have slightly higher interest rates than regular refinancing, because the lender is risking more money. This type of refinance is not right for every borrower. While the interest rate on this new debt will be much lower than credit card debt, the interest charges may be in the thousands, because they are spread over 30 years. Doing this also converts unsecured credit card debt into debt that is secured by the home.
Another reason homeowners refinance is to get out of a mortgage type that may become unaffordable. This includes getting out of an adjustable rate mortgage (ARM), interest-only mortgage, piggyback loan or any other type of mortgage provision. Some homeowners who wish to avoid a balloon payment (or homeowners who have an ARM that is about to reset) can switch into a new fixed rate mortgage.
Many mortgage agreements include a provision allowing the lender to charge a fee if the homeowner pays down an existing mortgage with a home equity line of credit (HELOC) Before refinancing, it is important to find out if such a penalty exists and if refinancing will be worthwhile.
Prepayment penalties can be a substantial roadblock in refinancing. This clause in the current mortgage allows lenders to charge a penalty if the loan is paid off before 2-5 years. This fee may be a percentage of the unpaid balance or a full month's interest to protect the lender from losing a loan before it becomes profitable.
Refinancing also costs money in the form of closing costs, and refinancing a loan at a lower rate is not always the best decision when these costs are considered. The average closing costs on a $200,000 mortgage is around $3,700. While deciding to refinance, homeowners should consider how many months of the new lower payments it will take to recover the closing costs.
For example, if the mortgage payment is reduced by $157 after refinancing, it would take 24 months of lower payments to recover the average closing costs.
The cost of refinancing a mortgage include: an application fee, title insurance and title search, lender's attorney review fees and points and fees incurred by loan origination.
Refinancing a mortgage requires applying for a new loan, which is nearly the same process as taking out a first mortgage. This means borrowers must have acceptable credit, and go through the process of having account balances, employment and income verified.
Before applying for a refinance, you will need to consider the type of mortgage you want. You may opt for a 15-year or 30-year fixed rate mortgage, an adjustable rate mortgage, a jumbo loan, an FHA loan and many other choices.
You will also need to choose a lender. You do not necessarily have to refinance with your current mortgage company. A mortgage broker is the best option if you want to find the lowest rate available.
Once you have made your decision about the type of loan you want and the lender, you will submit an application and go through the loan application process. Along with meeting qualifications, the home will also be appraised. The lender will consider your income, assets, credit score, debt, value of the property and the amount you want to borrow. If the home's value has fallen, it may not be worth as much as you owe on the mortgage. In this case, you may have difficulty refinancing through conventional means.
If you owe more than your home is worth, you will have limited refinancing options,
as lenders typically require around 20% equity in the home to refinance. However there are options available.
If you meet the criteria, your underwater mortgage may be eligible to refinance under the federal Home Affordable Refinance Program (HARP). Not every underwater mortgage qualifies, as you cannot have any delinquent payments in the last 12 months. Fannie Mae or Freddie Mac must also own the mortgage.
The second option is the federal Home Affordable Modification Program (HAMP), which is for underwater mortgages with missed payments. HAMP is not actually a refinancing program, but instead changes the terms of the mortgage to lower payments for up to 60 months.
This final option is available to homeowners with an existing FHA loan. An FHA Streamline Refinance is the easiest and fastest way to refinance an FHA loan, because it does not require an appraisal of the home. The FHA will use the home's original purchase price as the current value, and it encourages underwater mortgages. There is also no verification of income, employment or credit required. .