Refinance Mortgages and Loans

What is a refinance? Refinancing means taking out a new loan to replace a loan that you already have. People refinance when they can get a new loan with better terms than their existing loan. That usually means at least one of these benefits:

• A lower interest rate
• A smaller payment
• A fixed interest rate

However, refinancing usually costs money and should only be considered when the benefits outweigh the costs.

Types of Refinancing

There are four common types of refinances:

• Rate and term refinance
• Cash-out refinance
• Cash-in refinance
• Debt consolidation refinance

A rate-and-term refinance simply means replacing one loan with another in the same amount. If you have a three-year auto loan with a $10,000 balance and replace it with a $10,000 loan with a lower payment, that’s a rate-and-term refinance.

A cash-out refinance lets you replace one loan with a larger loan and take the difference in cash. If you owe $200,000 on your mortgage and refinance it with a $250,000 loan, taking $50,000 for college, that’s a cash-out refinance. Homeowners often wrap their refinancing costs into the new loan. A refinance with costs wrapped in is called a limited cash-out refinance.

A cash-in refinance is the opposite of a cash-out refinance. Your new loan is smaller than the loan it replaces, and you bring cash in to lower the loan balance. People do this when they want to refinance a home loan with mortgage insurance. By reducing their balance to under 80% of the property value, they can cancel their mortgage insurance and save every month. 

Finally, a debt consolidation refinance uses one loan to replace several accounts. Consumers commonly undertake debt consolidation with credit card balances because credit cards have higher interest rates than most other loans. You could, for instance, pay off credit cards with 15%, 17%, and 22% variable interest rates with a personal loan that has a 10% fixed rate. The most common debt consolidation loans include home equity loans and personal loans.

Refinancing a Mortgage

Mortgage refinancing is what most of us think of when we hear the term “refinance.” Mortgage refinancing is common because most mortgages are quite large, and you pay them over many years. That means even a slight difference in interest rate – 1% or less – can make a big difference in what you pay over the life of the loan. 

With a $400,000 mortgage, for instance, the lifetime interest cost over 30 years is $373,021 at 5% and $287,478 at 4% – a difference of $85,743.

There are many ways to refinance a mortgage and save money:

Refinancing a mortgage to pay less interest

Mortgage interest rates are susceptible to ups and downs in the global economy and change frequently. If interest rates are lower than they were when you got your home loan, it can make sense to refinance. You may also get a lower rate if your credit score has improved significantly since you got your existing loan.

One way to pay less interest is to refinance to a loan with a shorter term. Not only do you save by paying off your loan sooner, you can also save because mortgage rates for 15-year loans typically run .5% to 1% lower than rates for 30-year mortgages. 

Refinancing for a lower mortgage payment

If your debt payments are higher than you can comfortably handle, or you need to find money for another use, refinancing for a lower payment makes sense. There are three ways to reduce your mortgage payment with a refinance:

• Refinancing to a lower interest rate
• Extending your repayment time
• Dropping mortgage insurance coverage
• Refinancing to pay off a second mortgage

Refinancing to a lower interest rate is an obvious way to lower your payments. But extending your repayment period also lowers your expense. 

Suppose that you have a 30-year $300,000 mortgage at 4.5% and your payment is $1,520.06. After five years, your balance is $273,473. If you refinanced to a new 30-year loan, even at the same 4.5% interest rate, your new payment would be $1,385.65. And if you were able to lower your rate to 4%? The new payment would be $1,305.60. Note that your overall costs increase when you extend repayment on a mortgage or any other loan. 

Finally, if you have a loan with mortgage insurance, refinancing to lower or eliminate your coverage can save you hundreds even if you don’t reduce your interest rate. For example, the monthly mortgage insurance premium for a 95% FHA home loan is $212.50. Eliminating it or replacing it with cheaper private mortgage insurance could save you thousands over the life of the loan.

Refinancing to pay off a second mortgage

If you took out a second mortgage to buy your home or borrowed with a home equity loan or HELOC, you might be able to pay less interest and reduce your total monthly payment by wrapping both mortgages into a new refinance loan. Have your lender run the numbers to see if that’s a good option.

Streamline mortgage refinancing

Streamline refinancing can save you time and money. All government-backed mortgages and some private mortgages offer this feature. A streamline refinance may require no appraisal and no credit or income underwriting. That’s because the government or your current lender is already on the hook if you default on your loan, but refinancing to a more affordable one can lower the chance of that happening.

When Does Refinancing Make Sense?

Refinancing makes sense when it accomplishes what you want. If you’re trying to save money by refinancing, ensure that the new loan will do that by analyzing your refinance breakeven. A refinance breakeven means the time it will take for the amount you save each month to cover the cost of refinancing. 

For instance, if your refinancing costs are $2,000, and you’d save $100 per month by refinancing, your breakeven period is 20 months. As long as you have your new loan for at least 20 months, refinancing will save you money. 

Note that the difference in monthly payment is not savings if it mainly comes from extending your repayment. You can find true savings by using a mortgage refinance breakeven calculator.

If refinancing to lower your monthly payment, understand that this may increase your overall costs, even if the new loan has a lower interest rate. If you refinance a 30-year mortgage to a new 30-year mortgage after five years, your total time to pay off the loan is 35 years. That’s five extra years of payments. It might still be a valid refinance – if, for instance, you use the money freed up to pay down high-interest debt, you save money overall. Just run the numbers so you understand the actual cost of your new loan.

Pros and Cons of Refinancing

Before refinancing a loan, understand the pros and cons.

Refinancing pros

• Refinancing can lower your interest expense if you get a better rate.
• Refinancing can reduce your monthly expenses.
• You might be able to get cash at a reasonable cost.
• You can exchange a variable interest rate for a fixed rate, which helps control cost and make budgeting easier.

Refinancing cons

• Refinancing costs money. With so-called “no-cost” refinances, you pay with a higher interest rate.
• Refinancing extends the time it takes to clear the debt and can increase interest costs over the life of the loan.
• Refinancing can be a pain if you have to apply and document your income and assets.