Refinance Guide

What is a Mortgage Refinance?

Refinancing a mortgage involves replacing your existing home loan with a new one. This is often done to achieve various financial goals such as lowering the interest rate, reducing monthly payments, or accessing the equity built up in the home. Some homeowners refinance to pay off their mortgage quicker, eliminate FHA mortgage insurance, or transition from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage.

Before diving into the refinancing process, it’s crucial to understand some key elements and considerations. Following this, we can explore the refinancing process in a step-by-step manner.

How does Refinancing Work?

When purchasing a home, you usually finance it through a mortgage, where the lender gives the payment to the seller, and you repay the lender, typically in monthly installments.

Refinancing your home means obtaining new mortgage debt. In this case, instead of the lender paying the seller as in a home purchase, the lender uses the funds from the new mortgage to pay off your existing home loan. Your repayment is then based on the terms of this new mortgage.

Just like when you initially acquire a mortgage for a home purchase, the refinancing process involves submitting an application, undergoing an underwriting process, and completing the transaction at closing.

How Much Does Refinance a Mortgage Cost?

Refinancing your mortgage typically incurs costs ranging from 3% to 6% of your principal amount, in addition to any prepayment penalties or other charges for settling existing mortgages. These fees can vary based on your location and the lender you choose. Here’s a breakdown of common refinancing fees and their typical cost ranges:

1. Application Fee (Cost range: $75 to $300). This fee is for processing your loan request and checking your credit report. Note that this fee is often non-refundable, even if your loan application is denied.
2. Loan Origination Fee (Cost range: 0% to 1.5% of loan principal). Charged by lenders or brokers, this fee covers the evaluation and preparation of your mortgage loan.
3. Points (Cost range: 0% to 3% of loan principal). Points are prepaid interest, with one point equating to 1% of your loan amount. There are two types: loan-discount points for reducing the interest rate, and points charged by lenders or brokers to earn money on the loan. The number of points can often be negotiated.Tip: Consider how long you plan to keep the mortgage to determine if it’s worth paying points upfront. Refinance points might not be fully tax-deductible in the year they are paid.
4. Appraisal Fee (Cost range: $300 to $700). This fee is for valuing your home to ensure it’s worth at least the loan amount. You’re entitled to a copy of the appraisal, but you need to request it.
5. Inspection Fee (Cost range: $175 to $350). This covers inspections for termites, structural conditions, septic systems, and water systems, with requirements varying by state.
6. Attorney Review/Closing Fee (Cost range: $500 to $1,000). This is for the legal review and closing conducted by the lender.
7. Homeowner’s Insurance (Cost range: $300 to $1,000). Required to protect against damage to your home, this insurance must be in effect at settlement.
8. FHA, RDS, or VA fees or PMI. These fees are for loans insured by government programs or private mortgage insurance, applicable when borrowing over 80% of your home’s value.
   • FHA Loans: 1.75% upfront, 0.55% for FHA Streamline refinance loans.
   • RDS: 1.75% upfront.
   • VA: 1.25% to 2% upfront.
   • PMI: 0.5% to 1.5% annually.
9. Title Search and Title Insurance (Cost range: $700 to $900). These fees are for verifying your ownership and insuring the lender against title errors.Tip: Check with your current title insurance provider for a potential discount on reissuing a policy for a new loan.
10. Survey Fee (Cost range: $150 to $400). Required to confirm the location of your property and structures. A recent survey might waive this fee.
11. Prepayment Penalty. Some lenders charge a penalty for early mortgage payoff. Federal loans and some states prohibit these fees.

Tip. Before closing, request a copy of the HUD-1 form a day in advance to review all terms and charges.

Advantages Of Refinancing

A key benefit of refinancing a mortgage, irrespective of the equity held, is the potential to secure a lower interest rate. As individuals progress in their careers and improve their financial stability, they often find that they can manage their bills more effectively, leading to an improved credit score. This enhanced credit standing can enable them to obtain loans at more favorable rates. Refinancing a mortgage for a lower interest rate can significantly reduce monthly payments, potentially saving hundreds of dollars annually.

Refinancing a mortgage also presents an opportunity to eliminate private mortgage insurance (PMI), which is a significant advantage for many homeowners. PMI is typically required for borrowers who initially purchased their home with a down payment of less than 20% of the home’s value. This insurance protects the lender in case of borrower default but can add a substantial amount to the monthly mortgage payment, often ranging from 0.2% to 2% of the total loan amount annually. As homeowners build equity in their property, either through market appreciation or by paying down the principal, they may reach the point where their equity exceeds 20% of the home’s current value. At this juncture, refinancing can allow them to renegotiate the terms of their mortgage, potentially removing the requirement for PMI. This step can lead to significant savings, reducing the overall cost of the loan and lowering monthly payments, making the financial burden of homeownership more manageable.

Another common reason for refinancing is to access cash for major expenditures, such as buying a car or paying off credit card debt. This is achieved through a cash-out refinance, which involves tapping into the home’s equity. The process begins with an appraisal of the home to determine its current value. The lender then decides what percentage of this appraised value they’re willing to lend. The amount still owed on the original mortgage is then deducted from this value. The original mortgage is paid off with this amount, and the remainder is given to the homeowner. As homeowners often enhance their property’s condition, thereby increasing its value, and simultaneously pay down their mortgage, they can sometimes secure substantial amounts through home equity lines of credit. This is especially true as the gap widens between the appraised value of their home and the remaining mortgage balance.

Risks Of Refinancing

A significant risk associated with refinancing your current loan is the potential for penalties arising from paying off your existing mortgage with a new line of home equity credit. Many mortgage agreements include clauses that permit the lender to charge a fee for early repayment, and these fees can be substantial, sometimes amounting to thousands of dollars. It’s crucial to understand these potential penalties before finalizing a refinancing deal, ensuring that the transaction is still financially beneficial even after accounting for such costs.

Additionally, there are other expenses to consider when refinancing. These include legal fees for hiring an attorney to help navigate the deal and ensure its favorability, as well as to manage complex paperwork. There are also various bank fees involved in the refinancing process. To mitigate or avoid these bank fees, it’s advisable to compare offers from different lenders or to wait for opportunities that offer low or no refinancing fees. While the immediate savings from a new line of credit may seem attractive, it’s important to weigh these against the long-term savings from avoiding high refinancing costs.

Why Should You Refinance Your Mortgage?

Reducing Your Interest Rate

The interest rate on your mortgage significantly affects your mortgage payments – lower rates often result in lower monthly payments. You might secure a lower rate due to market changes or an improved credit score. This can help you build home equity faster and boost your monthly savings. For instance, the difference in monthly payments for a $200,000, 30-year fixed-rate loan at 5.5% versus 6.0% is $63, adding up to $756 annually and $7,560 over 10 years.

Altering Your Mortgage Term

• Extending the term can reduce monthly payments but increases the total interest paid over the life of the mortgage.
• Shortening the term often results in lower interest rates and less total interest paid, although monthly payments are higher. For example, a $200,000 loan at 6% for 30 years has a monthly payment of $1,199 and total interest of $231,640, whereas a 15-year loan at 5.5% has a monthly payment of $1,634 but only $94,120 in total interest.

Tip: You can also shorten your mortgage term by paying extra on the principal each month.

Switching from an Adjustable-Rate to a Fixed-Rate Mortgage

If you currently have an adjustable-rate mortgage (ARM), your payments vary with interest rates. Switching to a fixed-rate mortgage provides stability in payments, which can be beneficial if interest rates are expected to rise.

Tip: Fixed-rate loans with escrow can still fluctuate due to changes in property taxes, insurance, or association fees.

Refinancing for a Better ARM

If you have an ARM, consider refinancing to another ARM with more favorable terms, like a lower starting rate or smaller rate adjustments.

Tip: When refinancing ARMs, compare the initial and fully-indexed rates and ask about potential rate adjustments.

Cash-Out Refinancing

This involves refinancing for a higher amount than what you owe and receiving the difference in cash, useful for things like home improvements or education costs. However, it reduces your home equity and requires time to rebuild it.

Tip: Be cautious with cash-out refinancing for paying off unsecured or short-term secured debts. Consulting a financial adviser is advisable.

Refinancing from FHA to Conventional Loan

If you’ve built up enough home equity, you might be able to refinance from an FHA loan to a conventional loan. This can eliminate the need to pay the mortgage insurance premium (MIP), potentially saving you money in the long term. This is particularly advantageous for those who have reached the equity threshold where MIP is no longer necessary.

Tip: Compare the overall costs and benefits of switching from an FHA to a conventional loan, including any potential differences in interest rates and loan terms.

Refinance Process

Refinancing a mortgage involves a series of steps:

• Assess Your Goals. First, determine why you want to refinance. This could be to lower your interest rate, decrease monthly payments to save money, change the loan term, switch loan types, or tap into home equity.
• Review Your Financial Situation. Check your credit score, as a higher score can lead to better refinance rates. Understand your home equity; more equity can improve refinance options. Also, consider your debt-to-income ratio, which can affect loan eligibility.
• Research and Compare Options. Shop around with different mortgage lenders to compare rates and terms. Look into various types of loans (like fixed-rate or adjustable-rate) and fully understand the interest rates and fees involved.
• Apply for Refinancing. Submit a refinance loan application to your chosen lender, including necessary documents like financial statements, proof of income, and employment verification. The lender will conduct a credit check.
• Undergo Loan Underwriting. The lender will review your application and financial details. A home appraisal may be required to assess the current property value.
• Lock In a Rate. If you’re offered a favorable interest rate, consider locking it in to protect against future market changes.
• Close on the Loan. Carefully review the closing documents and understand all terms. Be prepared for closing costs, which can include various fees. Sign the paperwork to finalize the refinance.
• Manage Post-Refinance Actions. Adjust your budget if your monthly payments have changed. Make sure your old mortgage is paid off and closed. Keep all related documents for your records.

Refinancing Calculators

Online mortgage refinance calculators are tools designed to help you evaluate the benefits of refinancing your mortgage. To use these calculators, you need to input details about your existing mortgage, such as the outstanding balance, current interest rate, and remaining duration. Additionally, you should provide information about the proposed new loan, including its principal amount, interest rate, and loan term. The calculator may also ask for other financial details, such as your tax rate and potential investment returns, to help assess if investing the savings from refinancing is a viable option. These calculators typically display the net savings you might realize after accounting for all costs associated with refinancing. This information can help you decide if a refinancing offer is advantageous. An example of such a calculator can be found on the National Bureau of Economic Research’s website, under the title Leaving the Board.