Learn when it’s the right time to refinance your home loan, so you can protect your most important asset.
Maybe you got an offer in your mailbox or inbox, telling you the amazing rates available to refinance your home. But if you are new to the home-owning game, you might not even understand what refinancing is. Before you decide if you should refinance your mortgage, let’s understand more about what it entails.
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What does refinancing mean?
In the simplest of terms, refinancing is when you take your existing home mortgage and transfer the balance into a new loan. The primary goal is usually to get more favorable, more stable, interest rates. Refinancing is especially helpful for those who take out adjustable-rate mortgages or ARMs. ARMs tend to have very low interest rates for the first three to five years. But after those 3-5 years, the interest rate skyrockets, often leaving homeowners with a loan they can’t afford. (This is a piece of what caused the financial crisis in 2008.)
Individuals can choose to refinance into different home loan options, including 15- or 30-year loans. These loans offer fixed rates. That means homeowners pay the same amount every month for 15 or 30 years until their home is paid off. Refinance mortgage rates are often more favorable to borrowers than the initial mortgage rate.
Other reasons for refinancing a home
Some other reasons people refi is to borrow from the equity in their home to fix or make upgrades on their house. This is often called a cash-out refinance. If you use a cash-out refi for home improvement, it can help with the long-term value of the home. You effectively increase the resale value of your biggest asset.
You can also use that money to pay off high-interest rate credit cards or other personal loans that could be costing you. Some people use the funds from the mortgage for other purposes, such as paying for college and making investments.
How does a mortgage work?
A mortgage is the common way of saying a home loan. Technically, a mortgage is what gives you the right to the property, like a deed of trust. A mortgage note or promissory note is the actual home loan.
But a mortgage (or deed of trust) is what tells the bank: “Hey, I’m going to pay you monthly for this house. If I don’t pay you, then you have the right to foreclose on the house and take it back.” Mortgages have to go through the court in order to start the foreclosure process, but deeds of trust do not. It depends on which state you live in as to which home loan your lender uses.
When you decide to buy a house, you will have to take out a loan. Most people simply don’t have the kind of cash you need to buy a home just lying around. You will have to figure out how much you can put down on the home, and how much you can afford to pay on the home monthly (make sure to include HOA fees, electricity, water and more). Homebuyers usually put down up to 20 percent and finance the rest in what becomes the mortgage.
These home loans have a set interest rate that you pay monthly for the life of the loan.
Adjustable-rate mortgage (ARM)
Often written as 5/1 ARM or 3/1 ARM, the most popular of these come in 5-year and 3-year terms. But they are also available for longer adjustment periods. The rate is fixed for the first part of the loan, then adjusts annually after that for the life of the loan, which is usually 30 years.
Veterans can receive a mortgage from a lender with Veterans’ benefits. VA mortgage rates tend to be comparable or less than traditional mortgage rates. They also have no private mortgage insurance (or PMI) payments and require no down payment on a home to qualify.
When you get your first mortgage, or when you refi, you must have the house appraised. This verifies that the amount you want to borrow is less than what the house is worth. This way the house can be used as collateral for the bank in case you default on the loan. Once the amount is confirmed, you can continue along with your initial mortgage or refinanced mortgage.
The money from the loan goes into an escrow account (an account that keeps the money safe) where it will be transferred to the seller or the bank that the money is owed.
Benefits of refinancing
The biggest reason people refinance is that it saves them money in the long run. By reducing interest charges, you pay less money over the life of the loan. The rule of thumb that many lenders use today is that it is worth it to refinance if you will reduce your interest rate by at least 1 percent.
Years ago, the rule of thumb was reducing your interest rate by 2 percent, but rates are historically lower today than they were 25 years ago. These are some of the most popular ways that homeowners refinance:
Refinancing from a 30-year mortgage to a 15-year mortgage
The benefit that people achieve here is that their home will be paid off sooner. When people choose this option, the payments tend to be in line with what they paid on a 30-year loan. However, since the term is much shorter, total interest charges are reduced. So, you save money over the life of the loan.
Refinancing from an ARM to a fixed-rate loan
As explained earlier, ARM stands for adjustable rate mortgage. After a set time, your mortgage rate changes depending on the markets it is tied to for the year. This could quickly put a homeowner’s payments out of reach if they are on a budget. The benefit of refinancing to a fixed-rate loan is that the loan’s interest rate stays the same for the life of the loan. That means you usually don’t have to worry about sudden payment jumps, except for those caused by property tax increases.
Refinancing as a way to get a home improvement loan
While there are options to taking out a home loan, including home equity loans and HELOCs, or home equity lines of credit, refinancing allows you to retain a single mortgage, often with a better rate. This way you are getting a lower rate on all the money you are borrowing, and not just money on a home equity loan, which is essentially a second mortgage. Private loans or credit cards can also be an option when you are renovating. But again, interest rates can cause these options to become less attractive.
If interest rates are favorable, a cash-out refi can also be helpful if you have significant credit card debt and are paying steep interest fees. The additional money you receive could allow you to pay off your debts in one lump sum, with only one lower interest payment each month. If you do this, however, you must be mindful to not fall into credit card debt again, because you do not want to put your home in jeopardy.
Refinancing a mortgage after a divorce
Oftentimes after a divorce, one party will get ownership of the house in the settlement. When this happens, the homeowner will usually refinance in order to make more manageable payments for themselves. It also gets the loan solely in one person’s name. It can sometimes be difficult to get a mortgage loan refi though if the individual does not have enough income or assets. Those looking to refinance after a divorce should speak with a housing professional.
How to refinance a mortgage
When you decide you want to refinance your home, you will need to visit your mortgage broker or lender. They will start the process of your refinancing and determine the amount you are eligible to refinance. After you authorize a credit check, they’ll also tell you your interest rate based on your credit and other financial factors. You will start by locking in an interest rate while you compile your necessary paperwork.
A bank must look at several financial documents during refinancing. You will also need to have your home appraised before getting approval on a refinance loan.
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Note that there may be other documents, including Social Security benefit statements or proof of alimony payments. Provide all documents requested promptly to avoiding stalling out your refi.
What to expect during the underwriting process
The lender will go through all your paperwork, and likely request more as the appraisal is being completed. You will then receive final approval on your loan and final paperwork will be compiled for you to sign. There will be closing costs associated with your loan, just as with your original mortgage.
The cost to refinance will vary depending on your loan amount and the state you live in. Loan refinancing can take time, so be prepared that your refi won’t happen overnight. Your locked-in rate will guarantee that your interest rate won’t go up during this time.
Once you know your final closing costs and any potential real estate taxes, get a certified check or money order made out in that amount that can be used the day of the closing.
You will receive your final closing paperwork three business days before the actual closing. Make sure there are no last-minute changes.
On the day of the closing, you will likely have a real estate attorney present, along with the lender from the bank and any other participants, such as closing agents, who helped with your paperwork. You will sign your new mortgage or deed of trust, the promissory note and any other needed paperwork verifying the loan is yours and that you will pay it back. Your escrow account arrangements will also be finalized at this time.
Right of rescission
You usually have three business days to keep the loan if the home is your primary residence. This is known as the “right of rescission.” If you have second thoughts or feel that the terms of the loan are not what you originally agreed upon, you can rescind the loan at this time and give back the money, not including closing costs.
Article last modified on March 5, 2019. Published by Debt.com, LLC.
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