Monday, April 22, 2024

Mortgage Refinancing: How Does It Work?

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Mortgage rates started to climb in late 2021. As a result, refinance activity decreased gradually and subsided altogether by 2023. During the initial quarter of 2023, the number of new loans initiated for homeowners who refinanced their current mortgages amounted to only $47 billion.

The figure is 90% lower than the refinancing originations in the first quarter of 2021. Likewise, mortgage rates are expected to remain high for the foreseeable future, so refinancing is also anticipated to stay relatively low until at least 2023.

The upside to mortgage rates is that they’re not permanent. Many experts believe that mortgage interest rates will start to decline in 2024. Although opinions vary on how far they’ll drop, a slight decrease can make refinancing worthwhile.

Regardless, it’s crucial to understand the entire refinancing process and what it may mean for you. Remember, refinancing your mortgage could be on the horizon for different reasons. In this article, let’s explore how mortgage refinancing works and if it’s right for you.

What It Means To Refinance a Home

You’ve likely heard about refinancing if you own a home with a mortgage loan. A home refinance means obtaining a new loan to replace your mortgage. It’s different from getting a second or additional mortgage, such as home equity loans.

Refinancing your mortgage doesn’t mean redoing it. Instead, you’re changing aspects of your current mortgage, ideally for a lower interest rate or a better term that fits your financial goals. It’s called refinancing since the lender pays off your old mortgage with a new one.

With the closure and satisfaction of the old account, you must follow the terms of the new mortgage until you fully pay it or decide to refinance again. The new mortgage loan can originate from the same or a different lender.

There might be advantages to refinancing with your existing lender. For instance, working with them might speed up the closing process, or they might offer good customer service.

Whatever the potential benefits, it’s crucial to understand the new loan terms and ensure that they meet your refinancing goals before committing to anything. Even if you have already worked with the lender, you must check everything to ensure you get the best possible deal.

That’s why it’s wise to shop around and explore what other lenders can offer you. This way, you can ensure your current lender offers the best refinancing deal or find the lender most suitable for your goals and needs.

Different Types of Mortgage Refinancing

Due to the variety of borrowers and properties available, numerous types of mortgage refinancing exist. The right choice depends on your current needs and financial priorities.

Before making a decision, carefully consider the refinancing options available to you. It’s important to note that your choice can affect the loan requirements. Here’s a breakdown of each type of mortgage refinancing:

Rate-and-term refinance

This is the most direct form of refinancing. With a rate-and-term refinance, you can adjust your mortgage’s interest rate and loan duration while maintaining the same principal balance. That means the size of the mortgage loan remains unchanged.

How does that benefit you? Although the outstanding mortgage balance stays the same, you can reduce your monthly payment due to a lower interest rate or a more extended repayment period. However, that depends entirely on the changes made to the loan.

Only consider this option if you can negotiate a lower interest rate. Typically, you may qualify for a lower interest rate if market rates drop or your credit has improved since you initiated the original mortgage loan.

Cash-out refinance

A cash-out refinance enables you to access your home equity or the amount of your home’s value you’ve already paid off. The process involves securing a new loan that exceeds the amount you owe on the existing mortgage.

The new mortgage is typically larger than the old one to pay off the previous balance. You can withdraw the remaining funds in cash for a different purpose, such as home renovation projects or investments. There are no restrictions on how you use the extra funds.

Remember that a cash-out refinance doesn’t mean adding another monthly payment to your bill list. Since the larger mortgage replaces your existing loan, you only have a different monthly payment amount under the new agreement.

As a result, a cash-out refinance can be one of the most inexpensive ways to pay for significant expenses. Still, carefully review the new terms and understand how the new mortgage will affect your budget.

Cash-in refinance

A cash-in refinance involves making a lump-sum payment on your mortgage loan during refinancing. Doing so allows you to replace your existing mortgage with a new one with a smaller principal balance.

Besides reducing the size of your new loan, paying a lump sum will ultimately lower your monthly payments compared to your current mortgage. Suppose you’ve recently come into a large sum of cash. Refinancing can be a good option to decrease overall borrowing costs.

You can also opt for cash-in refinance if your mortgage exceeds your home’s value or you don’t have enough home equity. Remember, there’s often a minimum equity requirement to get approved for a home refinance. Paying a lump sum can help you reach the required equity.

Reverse mortgage refinance

A reverse mortgage is a form of refinancing available to borrowers over 62 with substantial home equity. It works the same way as refinancing a traditional mortgage. Borrowers exchange the current loan for a new one that fits their financial situation.

Unlike a conventional mortgage that requires monthly payments, refinancing with a reverse mortgage enables you to convert some of your home equity into cash. You can get the funds as a lump payment, a line of credit, or a fixed monthly income.

The main advantage of this refinancing option is that you don’t have to pay the loan as long as you live in the house. However, the loan balance becomes due to the lender once the borrower moves out, sells the home, or dies.

The loan can be paid through the home sale proceeds or payments made by the heirs after a standard refinance.

No-closing-cost refinance

As the name implies, a no-closing-cost refinance doesn’t require you to pay closing fees upfront when you obtain a new loan. However, it doesn’t mean you eliminate the closing costs.

Instead of paying them out of pocket, you roll the closing costs into the new principal loan balance. That means the lender adds the balance of your refinance closing costs to the principal amount. While that won’t impact your interest rate, your monthly payments will increase.

Another option is to have the lender cover the fees at a higher interest rate. This will not affect the total amount you’ll pay throughout the loan. Still, you’ll pay more monthly and incur higher total interest over time.

No-closing-cost refinance is viable if you intend to live in the home for a few years. You may also want to consider it if you need to access the funds typically allocated for closing costs to pay for other expenses.

Streamline refinance

A streamlined refinance enables you to refinance your current mortgage with minimal documentation and paperwork. This option waives some refinance requirements, such as appraisals and credit checks.

As a result, turnaround times are typically faster, and closing costs are lower than with traditional refinancing. However, this refinancing is only available for specific loan programs, such as the following:

  • FHA Streamline Refinance: This is accessible to borrowers with existing Federal Housing Administration (FHA) loans. You can only qualify for this option if your current mortgage is up-to-date and already insured by FHA.
  • VA Streamline Refinance: This is open to individuals with an existing mortgage backed by the US Department of Veteran Affairs (VA). It can help you obtain lower monthly payments and interest rates.
  • USDA Streamline Refinance: This is available to borrowers with US Department of Agriculture (USDA) loans with little home equity to reduce their interest rates and adjust their loan terms.

Short refinance

In a short refinance, the lender replaces the existing mortgage with a lower-balance loan. As a result, the monthly payments are reduced to a level you can realistically afford. However, lenders may only offer this to homeowners who have defaulted on mortgage payments and are facing foreclosure.

Short refinance benefits those underwater on their mortgages who can’t secure regular refinance. Likewise, lenders can take advantage of this option, as they avoid the expenses associated with a short sale and foreclosure.

Unfortunately, it’s not easy to qualify for this refinancing option. Eligible borrowers must prove they’re facing financial hardship and are at risk of defaulting on a mortgage. Another downside is that your credit score will likely drop since you’re paying the total amount of the original mortgage.

How Refinancing a Mortgage Works

Refinancing a mortgage is similar to obtaining a first mortgage. However, the timeline is usually faster and less complex than home-buying, often taking between 30 and 45 days.

However, given the different circumstances, knowing precisely how long your refinance process will take can be difficult. Understanding the steps involved can help you ensure a more seamless refinance experience.

Determining your financial goals is critical before refinancing your mortgage like other loan types. After assessing your finances and finalizing your financial plan, you can start the refinancing process, which generally involves the following steps:

Application process

The initial step to a home refinance involves applying for a new loan, either with the same or a new lender. Before going to any lender, research their offers and requirements. Ask them for a rate quote on the loan type and program that suits your financial situation.

You can go through their application process once you find the best lender and option. Expect the lender to ask for your personal information and documentation about your financial situation and property details.

The lender will determine whether you qualify for a new loan based on the details you provided in the application. If so, they will specify the terms of the loan. It’s worth noting that you’re not obligated to proceed with the loan just because you applied.

You can compare different offers to see which makes the most sense. But be careful about multiple credit inquiries, affecting your credit score. Consider applying for mortgage refinancing with various lenders within a 45-day window so it won’t count as more than one credit inquiry.

Mortgage rate lock

Once approved, you can lock in your interest rate so it doesn’t increase before you close on the new loan.

Depending on the loan type and other factors, most lenders provide mortgage rate locks of up to 60 days. But remember, the shorter the time you lock in your rate, the more favorable the rate might be. Hence, ensure you promptly send your paperwork and contact your loan officer during the refinancing.

It’s crucial to note that you might have to extend the rate lock if your loan doesn’t close before the lock period expires. That might cost you extra for extension fees.

Alternatively, lenders may offer a mortgage rate lock with a float-down feature. With this option, you can lower your interest rate if it goes down during your lock period. It lets you benefit from lower rates if they occur while protecting yourself against increasing interest rates.

Home appraisal

Unless you qualify for an appraisal waiver, a licensed real estate appraiser will need to assess the value of your home. Similar to when you first got your mortgage, your lender will organize an appraisal of your property.

A home appraisal evaluates your property’s worth by comparing it to recent sales of similar homes in your area. Remember that your estimate might differ from the appraiser’s evaluation.

Since appraisers grade your home based on its condition, ensure it looks its best. Maintaining and upgrading your home can help you get a higher appraised value. You should also compile a list of any improvements you’ve made to the house since you’ve owned it.

How you move forward after the appraisal will depend on whether the appraisal matches the loan amount or returns a lower value. Suppose the home’s value meets or exceeds the refinance loan amount. The lender will contact you to arrange the closing.

On the other hand, if the appraisal is lower than the refinance amount, the lender may not approve the loan. In this case, you can opt for a cash-in refinance or bring cash to maintain the terms of your current deal.

Ensure the accuracy of the appraisal and identify any errors. Share your findings with your lender and request a review to correct the mistakes and update the valuation.

Underwriting process

After completing your home appraisal, an underwriter will review your loan for final approval. During underwriting, the lender will check your financial and property information to give the final approval for your loan.

Specifically, the lender will ask your current lender for a payoff statement and update your homeowner’s insurance to show the new mortgage company. When all requirements are met, you’ll be set for your refinance closing.

Mortgage refinance closing

Once underwriting and the home appraisal are complete, the final step is closing your loan. A few days before closing, you will receive a document from the lender known as a Closing Disclosure. It will specify the final loan terms and costs you’ll pay at closing.

Scrutinize it to ensure that the interest rate, closing expenses, and property details are correct. You’ll sign the documents and settle any unfinanced closing fees at closing. If you opt for a cash-out refinance, you’ll receive the funds shortly after the closing.

After closing on your loan, you have another three-business-day period before it becomes final. If it’s not in your best interest, you may exercise your right of rescission and cancel within three days.

What Mortgage Refinance Lenders Require

Mortgage lenders’ requirements differ depending on why you’re refinancing and how your finances look. Shopping around lets you compare what each lender requires and choose one that meets your lending needs. It can also help you find one that saves you money upfront and in the long term.

Understanding the requirements for refinancing a mortgage can help you prepare for approval, avoid unnecessary hassle, and reduce the likelihood of rejection.

As per the Home Mortgage Disclosure Act (HMDA) data, the denial rate for refinance loan applications stood at 24.7% in 2022. It significantly increased from 14.2% in 2021 to 13.2% in 2020. You can lower the likelihood of rejection by preparing to meet the loan qualifications.

Each lender’s requirements may vary. Still, most mortgage lenders examine the following factors when assessing someone’s eligibility for mortgage refinancing:

Minimum credit score

Poor credit score is one reason lenders may reject your application. Since it gauges how likely a borrower is to repay a loan, bad credit is a red flag to lenders.

The minimum credit score you need to be eligible for refinancing may vary depending on the lender and loan program. However, most mortgage refinance lenders seek at least 620 or higher credit scores. Government-sponsored mortgages are more lenient on this requirement.

Loan-to-value ratio

If your credit score meets the mortgage program’s requirements, lenders will look at your loan-to-value ratio. This ratio compares how much you still owe on your loan to how much your home is worth.

Most lenders may favor a loan-to-value ratio of 80% or less. If it’s higher, it might be a good idea to wait until you’ve paid off more of your existing loan or apply for a smaller loan amount.

Debt-to-income ratio

Lenders assess your debt-to-income (DTI) ratio. It compares the monthly gross income you put toward paying debts. Lenders may favor a debt-to-income ratio below 36%. They may also prefer no more than 28% dedicated to mortgage or rent payments.

You can still be eligible for a mortgage with a DTI ratio of up to 43%. Note that the maximum DTI ratio differs from one lender to another. So, the lower your debt compared to your income, the better your chances of getting approved for the refinancing.

Asset requirements

Refinancing comes with a closing cost. If you don’t roll these expenses into your loan, lenders will verify whether you have enough cash assets to cover them. Most lenders ask for enough reserves to cover one year’s expenses to manage the higher loan payment.

Your assets may include retirement account assets, balances in your bank accounts, and stock or brokerage accounts.

Income requirements

Your lender assesses your finances to establish the refinance interest rate. They will likely require proof of income during the application, such as tax returns, pay stubs, and employment history. You won’t need to provide this if you’re eligible for government-backed streamline refinance programs.

When It Makes Sense To Consider Refinancing

You might be considering refinancing your mortgage for various reasons. However, since it’s not a one-size-fits-all solution, it’s crucial to determine whether refinancing is a wise step for your financial circumstances.

Doing that requires careful consideration. Understanding when it makes sense to refinance your mortgage can help you make more informed choices. For most mortgage borrowers, refinancing is advantageous for the following reasons:

Lower monthly payments

Refinancing your mortgage is a prudent choice if you want to lower your payments every month. For example, you have a 15-year mortgage but are having trouble paying it.

You can decrease your monthly payments and alleviate some of the strain on your budget by refinancing to a longer term. But remember, this also entails paying more interest overall.

Switch loan types

You might consider a different loan type or program for various reasons.

For instance, you obtained an adjustable-rate mortgage (ARM) because its initial interest rate is lower than a comparable fixed-rate mortgage. However, you want to stabilize your monthly payments. It might be sensible to refinance your loan with a fixed-rate mortgage when the rates are still low.

Another example is you’ve built up substantial equity in your home. You could switch from a Federal Housing Administration (FHA) loan to a conventional loan. This change would prevent you from paying a mortgage insurance premium (MIP).

Reduce the loan term

If you’re making more money now and can pay your mortgage quicker, switching to a shorter-term loan could be a wise financial move.

However, remember that even though the interest rate is lower, your monthly payments will be higher because you’re paying it off faster. It’s essential to check if your budget can handle the higher payments before switching.

Tap equity for more funds

You can also tap your home’s equity and access more funds. With a cash-out refinance, you can borrow more than the amount of your existing loan and receive the remaining amount as cash.

You can use such funds to consolidate your debts. But that’s not all. You don’t need to use the money from your cash-out refinance solely for debt repayments. Since you can use this money for almost anything, you can increase your savings or cover home repair expenses.

Suppose you make a capital improvement in your home using the money from a cash-out refinance. The interest you pay on that amount can be tax-deductible.

Additional Considerations When Refinancing

While mortgage refinancing is appealing, it’s not suitable for everyone. Before deciding to refinance your mortgage, there are additional factors to consider. The following considerations can influence the outcome of your refinancing journey and empower you to make an informed decision:

Refinancing costs

How do you determine if replacing your current mortgage is worth it?

First, carefully examine the terms of your existing loan. You must understand the fees involved in refinancing your mortgage. The lower you pay on the refinancing costs, the more money you can save on interest.

As a result, you’ll see those savings adding up. That’s why considering mortgage refinancing costs is essential before pursuing it. Remember, the refinancing process incurs one-time expenses, known as closing costs.

You can anticipate paying around two to six percent of the loan on your new mortgage in closing fees. Using a mortgage refinance break-even calculator can help determine if the savings of the refinanced loan exceed the closing costs.

Long-term plans

How long do you plan to stay in your home? If you anticipate a longer stay, you can recoup the closing costs on your new loan. In that case, refinancing your mortgage may be a sensible choice for you and your budget.

You can allocate the amount you saved from a lower interest rate to pay other bills or for monthly savings. Suppose you’re unsure about your long-term plans for your home and seriously considering moving in the next five years. Refinancing might not be a good idea.

Prepayment penalty

A prepayment penalty is a fee the lenders charge if you repay your loan early. Depending on the lender, you might pay a hefty fee if you repay your loan within the first few years of borrowing it. This fee can make refinancing your mortgage more expensive.

Thus, before doing so, check the terms of your existing loan and whether it includes a prepayment penalty. If so, consider waiting three to five years before refinancing a mortgage. That’s usually when lenders dismiss the prepayment penalty.

Final Points To Remember

Determining whether refinancing is the most appropriate step depends on several factors.

As you already know, your current financial situation plays an immense role in the decision-making process. However, don’t forget about the general economic climate. You may consider delaying any considerable move when it’s volatile and interest rates are elevated.

It’s also crucial to be aware of the possible impact of applying for mortgage refinancing from multiple lenders simultaneously. They will likely result in hard inquiries on your credit report, which could hurt your score. Hence, check out your options before applying for multiple loans simultaneously.

Featured Image Credit: Photo by Andrea Piacquadio; Pexels

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