All material adapted or taken from Federalreserve.gov
What is refinancing?
When you refinance, you pay off your existing mortgage by taking out a new mortgage. You may also be able to combine a primary mortgage and a second mortgage into a single new loan.
Why might I want to refinance?
There are a number of different reasons why refinancing might be a good choice for you. These include:
Lowering your interest rate
The interest rate on your mortgage is tied directly to how much you pay on your mortgage each month–lower rates usually mean lower payments. You may be able to get a lower rate because of changes in the market conditions or because your credit score has improved. A lower interest rate also may allow you to build equity in your home more quickly.
Adjusting the length of your mortgage
You may want a mortgage with a longer term to reduce the amount that you pay each month. However, this will also increase the length of time you will make mortgage payments and the total amount that you end up paying toward interest.
Shorter-term mortgages generally have lower interest rates. Plus, you pay off your loan sooner, further reducing your total interest costs. The trade-off is that your monthly payments usually are higher because you are paying more of the principal each month.
Refinancing is not the only way to decrease the term of your mortgage. By paying a little extra on principal each month, you will pay off the loan sooner and reduce the term of your loan.
Changing from an adjustable-rate to a fixed-rate mortgage
If you have an adjustable-rate mortgage, or ARM, your monthly payments will change as the interest rate changes. With this kind of mortgage, your payments could increase or decrease.
If you are worried about your rates going up, you may want to consider switching to a fixed-rate mortgage which will have a steady interest rate and monthly payment. You also might prefer a fixed-rate mortgage if you think interest rates will be increasing in the future.
Getting an ARM with better terms
If you currently have an ARM, and you believe that the next rate adjustment will increase your monthly payments substantially, you may choose to refinance to get another ARM with better terms. For example, the new loan may start out at a lower interest rate, or offer smaller interest rate adjustments or lower payment caps, so that that the interest rate cannot exceed a certain amount. For more details, see the Consumer Handbook on Adjustable-Rate Mortgages
Taking out equity on your home
Home equity is the dollar-value difference between the balance you owe on your mortgage and the value of your property. When you refinance for an amount greater than what you owe on your home, you can receive the difference in a cash payment. This is called a cash-out refinancing. You might choose to do this if you need cash to make home improvements or pay for a child’s education.
However, when you take out equity, you own less of your home. If you need to sell your home, you will not put as much money in your pocket after the sale. If you are considering a cash-out refinancing, think about other alternatives as well. You could shop for a home equity loan or home equity line of credit instead.
Why shouldn’t I refinance?
There are a number of reasons why it might not be a good idea to refinance. Talk to your
NeighborWorks of Western Vermont homeownership advisor or a financial advisor before you go ahead with the any refinancing plan.
When you’ve had a mortgage for a long time
In the later years of your mortgage, more of your payment applies to principal and helps build equity, and less of your payment goes to paying off interest each month. By refinancing late in your mortgage, you will restart the amortization process, and most of your monthly payment will be credited to paying interest again and not to building equity.
When you have a prepayment penalty
A prepayment penalty is a fee that lenders might charge if you pay off your mortgage loan early, including for refinancing. If you are refinancing with the same lender, ask whether the prepayment penalty can be waived. You should carefully consider the costs of any prepayment penalty against the savings you expect to gain from refinancing.
Paying a prepayment penalty will increase the time it will take to break even once you account for the costs of the refinance and the monthly savings you expect to gain.
When you are planning to move soon
The monthly savings gained from lower monthly payments may not exceed the costs of refinancing–a break-even calculation will help you determine whether it is worthwhile to refinance, if you are planning to move in the near future.
How do I know if I can refinance?
Determining your eligibility for refinancing is similar to the approval process that you went through with your first mortgage. Your lender will consider your income and assets, credit score, other debts, the current value of the property, and the amount you want to borrow. If your credit score has improved, you may be able to get a loan at a lower rate. On the other hand, if your credit score is lower now than when you received your current mortgage, you may have to pay a higher interest rate on a new loan.
Lenders will look at the amount of the loan you request and the value of your home, determined from an appraisal. If the loan-to-value (LTV) ratio does not fall within their lending guidelines, they may not be willing to make a loan, or may offer you a loan with less-favorable terms than you already have.
If housing prices fell between when you purchased and when you want to refinance, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have a loan that includes negative amortization (when your monthly payment is less than the interest you owe, the unpaid interest is added to the amount you owe), you may owe more on your mortgage than you originally borrowed. If this is the case, it could be difficult for you to refinance.
How much does it cost to refinance?
It is not unusual to pay 3-6% of your outstanding principal in refinancing fees. These expenses are in addition to any prepayment penalties or other costs for paying off any mortgages you might have.
Refinancing fees vary from state to state and lender to lender. Here are some typical fees and average cost ranges you are most likely to pay when refinancing:
- Application Fee
- Loan Origination Fee
- Appraisal Fee
- Inspection Fee
- Attorney review / closing fee
- Homeowner’s Insurance
- Title search and title insurance
- Survey fee
- Prepayment penalty
What about “no-cost” refinancing?
Lenders often define “no-cost” refinancing differently, so be sure to ask about the specific terms offered by each lender. Basically, there are two ways to avoid paying up-front fees – but either way costs something in the end.
The first is an arrangement in which the lender covers the closing costs, but charges you a higher interest rate. You will pay this higher rate for the life of the loan.
The second is when refinancing fees are included in (“rolled into” or “financed into”) your loan--they become part of the principal you borrow. While you will not be required to pay cash up front, you will instead end up repaying these fees with interest over the life of your loan.