Refinance Mortgage: How Does It Work and Why Do You Need It?

8 mins read Nov 14, 2024
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Edited By

Prayas Biswas

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Editor
Edited By

Prayas Biswas

Editor, Houzeo
About

Prayas B. is a detail-oriented content editor specializing in American real estate. In his free time, he enjoys hitting the pitch for a game of football or watching motorsports.

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In Q2 of 2023, lenders issued over $141 billion worth of refinances across 477,219 mortgages. This number reflects the large share of borrowers who use mortgage refinancing to increase their monthly savings.

However, it is crucial to find a lender that offers terms suitable to you. Houzeo can help speed up this process. Check out our list of verified mortgage lenders near you, choose one, submit your application and begin the process. Don’t wait!

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What Do You Mean by Refinance Mortgage?

Refinancing replaces an existing mortgage with a new loan. Homeowners typically refinance their mortgages when interest rates drop, and home values rise. Refinancing allows them to easily tap into increased home equity.

Home equity is the portion of a property’s value that the homeowner truly owns. It is the difference between the home’s market value and the outstanding mortgage balance. You can estimate your home’s FMV with Houzeo’s most accurate home value estimator and subtract any outstanding mortgage balance

You can also refinance with your current lender for improved terms like a lower interest rate, or reduced closing costs . However, they might charge a prepayment penalty of up to 6% of the total loan amount for paying off the loan early.

What Are the Steps to Refinance a Mortgage?

Refinancing a mortgage is almost identical to getting a normal loan, with a few additional factors to consider:

Assess Your Situation 

Refinancing can reduce your mortgage costs, but only if the new interest rate is lower than your current rate. You’ll also need at least 20% home equity to get better loan terms from lenders. 

Before refinancing, carefully evaluate your situation. Carefully consider the new interest rates, closing costs, and the duration you plan to stay in your home. This will help you determine the feasibility of the refinancing exercise.

Shop Around

While your current bank is a good starting point for refinancing options, several other lenders might offer a better deal. A better deal could include more affordable interest rates and comparatively lower prepayment penalties. 

Note that requesting quotes from many lenders may negatively impact your credit score. This is because such queries are recorded in the central database and show that you conducted multiple enquiries. 

Gather and File Documentation

Once you have evaluated and compared different alternatives, it is advisable to streamline the documentation process. The most common documents you might require include:

  • Proof of income (pay stubs, tax returns, W-2s)
  • Credit report
  • Identification (driver’s license, passport)
  • Current mortgage statement
  • Homeowner’s insurance proof
  • Asset documentation (bank statements, retirement accounts)

Understand Interest Rates

When refinancing, you can lock in your interest rate to stay protected from rate increases. Conversely, a floating rate offers lower rates but has a risk of rising with market fluctuations. Choose based on your financial goals and risk tolerance.

Home Appraisal

For a refinance, your home’s appraised value is important. A professional appraiser will assess your home’s current value and calculate your equity. The lender approves the loan if the appraised value exceeds the loan amount.

If the appraisal is low, resulting in a high loan-to-value ratio, the lender may deny the loan. This can be addressed by lowering the loan amount or bringing in additional cash to reduce the loan-to-value ratio.

Run the Numbers

Assessing your financial situation is crucial to ensuring positive cash flow after refinancing a home loan. While there are several options for refinancing the loan, not all will suit you.

Compare the interest rates, repayment terms, and other conditions from various lenders. Calculate potential monthly payments, total interest costs, and overall savings to determine the most viable option for your financial situation.

Submit the Loan Application

Consult with the lender you choose to understand the application process thoroughly. Once you outline the steps involved, make the final submission. It will smoothen the process and help you ensure that all relevant documents are filed.

Close the Loan

Once you and the lender arrive at mutually acceptable terms and conditions, the loan can be formally closed. This process generally involves signing the loan agreement, settling the old loan and opening a new loan account.

What Are the Types of Mortgage Refinance?

As each borrower has their unique circumstances and needs, here are different various types of mortgage refinance solutions:

  1. Rate-and-Term Refinance: A rate-and-term refinance is the most basic type of mortgage refinancing solution. In this type of refinance, either the rate or loan term or both are modified.
  2. Cash-Out Refinance: With a cash-out refinance, you turn your home equity into active funds by replacing your existing mortgage with a new one. You get the difference in cash between the two mortgages.
  3. Cash-In Refinance: As opposed to cash-out refinance, borrowers pay the lender in a lump sum to reduce their loan-to-value ratio in cash-in refinance. This way, their monthly payments and overall debt are reduced. However, their liquidity takes a hit.
  4. No-Closing-Cost Refinance: A no-closing-cost refinance allows borrowers to refinance their mortgages without paying the closing cost for the old one. However, this is not an exemption from the closing costs. It is rolled up with the new mortgage and paid with the monthly installment.
  5. Short Refinance: Short refinance is a type of principal reduction or principal forgiveness. In it, the lender offers a new loan that is significantly lower than the original loan and forgives the balance. It is generally done when borrowers face financial difficulty and fear foreclosure.
  6. Reverse Mortgage: As the name suggests, a reverse mortgage is when the lenders pay monthly installments to the borrowers. The borrowers finance their home equity in a reverse mortgage. Then, instead of collecting the whole amount in a lump sum, they take monthly installments. 
  7. Debt Consolidation Refinance: Debt consolidation refinance is much like cash-out refinance where the borrower gets a significant amount of cash in hand against their home equity. However, unlike cash-out refinance, debt consolidation refinance restricts the use of money for debt consolidation only.
  8. Streamline Refinance: In a streamlined refinance, the procedure is streamlined by eliminating various steps like credit checks or appraisals. It ensures that the borrowers get the finances without any undue delays. The option is generally available for FHA, VA, USDA, and Fannie Mae, and Freddie Mac loans.

Is Mortgage Refinancing the Right Option for Me? 

A home is a major investment, and refinancing a home loan helps you capitalize on that investment. Beyond this, homeowners can refinance their mortgages for other benefits. Here are a few aspects of a loan that refinancing can affect positively:

  • Interest Rate: The main advantage of refinancing a mortgage is securing a lower interest rate. The new rate could often be up to 2% lower, which can significantly impact your payouts. 
  • Loan Term: You can also change your loan term by refinancing your mortgage. Several lenders offer prepayments with no, or minimal penalties to help reduce the loan term. 
  • Loan Type: Another major benefit of refinancing mortgages is that you can switch your loan type during the procedure. This is especially beneficial if your current mortgage type no longer aligns with your financial goals.  
  • Debt: Refinancing mortgages can also help consolidate debt by combining multiple debts. It allows debts like credit cards and student loans to be subsumed into a single loan.

What Are the Potential Challenges of Refinancing a Mortgage?

The challenges associated with refinancing a mortgage are not very apparent and, therefore, easy to ignore. However, it is crucial that you consider certain downsides before proceeding with a mortgage refinance:

Added Costs

The main thing to consider is the high closing costs of refinancing, typically 3-6% of the loan amount. These costs are paid upfront, so they’re important to factor in. 

These can lead to significant financial strain while trying to refinance a mortgage. This is why you should consider whether the overall cost savings from refinancing outweigh the closing costs.

Equity Concerns

Refinancing a mortgage includes holding the home equity as collateral, which significantly reduces the owner’s stake. Many don’t consider this as a significant risk since the equity eventually builds up. 

However, homeowners may lose their homes if they defer the payments. It is crucial to account for possible future financial constraints and contingencies. You must plan ahead to keep making timely payments.

Credit History

Refinancing can also impact your credit score, as applying for a new loan involves a hard inquiry. This might temporarily lower your score. Additionally, closing the old loan and opening a new one can further affect your credit history.

Bottom Line

Refinancing your mortgage can help secure a significantly lower interest rate on the new loan, or access home equity for major expenses. Once you evaluate your current mortgage, check if refinancing aligns with your long-term financial goals.

The next step is to find a lender suited to your needs. Check out Houzeo’s list of reputable mortgage lenders nearby to speed up your search process. So, don’t delay; begin your mortgage refinancing journey with the help of experts right here!

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Frequently Asked Questions

Is it better to refinance your mortgage?

Refinancing is generally beneficial as it lowers your interest rate, reduces your monthly payments, or shortens your loan term. However, weighing the costs and benefits is essential.

Does refinancing hurt your credit?

Refinancing can temporarily lower your credit score due to the hard inquiry and the impact of closing old accounts and opening new ones. However, the long-term effects depend on how you manage the new loan.

How much does refinancing a mortgage cost in the USA?

Refinancing costs can be a potential challenge associated with this process, and range from 3% to 6% of the original loan amount. These costs include application fees, origination fees, appraisal fees, and closing costs. They vary depending on the lender and loan terms.

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