What does Refinancing a Mortgage Mean?

What does Refinancing a Mortgage Mean

If you’ve been building equity in your home, why not use it to your advantage? You can perhaps get a better interest rate, pay for a home renovation, or pay off other high-interest debts. You may be able to achieve any of these things and more by refinancing your mortgage.

What does it mean to refinance your mortgage?

Refinancing your mortgage essentially means changing the current terms of your mortgage or leveraging your home’s equity to borrow additional funds. 

Why refinance your mortgage?

Most people refinance their mortgage for three main reasons. They want to:

  • Lower the interest rate on their mortgage, thus helping to build equity in their home quicker.
  • Pay for a significant expense.
  • Or consolidate their debts into one streamlined source.

Let’s look at each of these reasons in more detail below.

Refinance to lower the interest rate on your mortgage

By refinancing, you may be able to lower the interest on your mortgage. Lowering the interest rate on your mortgage can help reduce your monthly mortgage payments. It can also help accelerate the pace at which you build equity in your home, as more of your payment will go towards paying down the principal balance and less towards interest costs.

It’s essential to be strategic as to when to refinance your mortgage to take advantage of lower interest rates. As a general rule of thumb, it’s best to consider refinancing your mortgage if you can save at least 1% to 2% on the interest rate. The more the interest savings, the better.

Refinance to pay for a significant expense

You may want to refinance your mortgage to pay for a significant expense, such as a home renovation or repair. By using the built-up equity in your home, you can borrow up to 80% of the value of your home. This can come in the form of a Home Equity Line of Credit (HELOC) or an upfront cash loan amount that you’ll have to pay back along with your regular mortgage payments.

Refinance to consolidate debt

Using your home’s equity to secure a source of financing, often has lower interest rates than other personal loan types. The lower interest rates on a Home Equity Line of Credit, for example, make it ideal for consolidating debts. 

If you have credit card debts, student loans, or car loans with high-interest rates, it may make sense to pay off all those debts using funds borrowed using your home’s equity. This way, you can consolidate all of your debts into one streamlined payment with a lower potential interest rate. 

How do I refinance my mortgage?

There are two primary ways you can refinance your mortgage. You can:

End your current mortgage term early and start a new one.

You can refinance your mortgage by concluding the current term of your mortgage early. This means that you’ll pay off your existing mortgage and get a new one with more favorable terms.

Be aware that if you have a closed rate mortgage, ending your mortgage term early can incur prepayment penalty charges. Be sure to check with your mortgage lender to see what these costs could add up to.

Get a Home Equity Line of Credit 

Another option to refinance your mortgage is to open a Home Equity Line of Credit (HELOC). A HELOC can allow you to tap into the equity of your home to give yourself an open revolving line of credit that you can use whenever you need it. 

Generally, you need to have built up at least 20% equity in your home before most lenders will approve you for a HELOC. 

To calculate how much of a HELOC you can be approved for, take 80% of the value of your home. Next, subtract the outstanding principal amount on your mortgage and any outstanding debt amounts that are secured by your home.

For example, say your home is worth $500,000. Multiple $500,000 by 0.8 to get $400,000. Let’s say you have a $250,000 balance on your mortgage. Subtract $250,000 from $400,000 to get $150,000. Let’s also say you have a $20,000 line of credit that’s secured by your home. Subtract $20,000 from $150,000 to get $130,000. This final $130,000 amount is the amount you can borrow by refinancing your mortgage.

Get an additional cash loan using your home’s equity

Refinancing your mortgage can also mean getting a cash loan upfront from your lender using the equity in your home. The cash loan is an additional loan amount that you’ll have to pay back along with your regular mortgage payments.

Considerations to make before refinancing

Before you refinance your mortgage, it’s essential to consider your current financial situation and any additional debt obligations and costs that refinancing your mortgage may cause.

Prepayment penalty charges

For closed term mortgages, you should be aware of any prepayment penalty charges that your lender may levy on you for breaking your mortgage term early. It’s best to consult your mortgage lender to find out how much you’ll have to pay for ending your term before it finishes.

You’ll also want to consider if the interest savings that you’ll receive by refinancing your mortgage outweigh the costs of a prepayment penalty charge. If the benefits don’t exceed the costs, then it may not be worth refinancing your mortgage.

Consider if you can afford to take on more debt

It’s essential to be aware of your current financial situation and the ability to take on any additional debts that come with mortgage refinancing. Do some analysis and consult a financial advisor to determine if refinancing your mortgage is the right decision for you.

As a rule of thumb, your total monthly debt payments and housing costs should not exceed more than 42% of your monthly income. For example, if you make $7,000 a month, your mortgage payment, car payment, condo fees, and heating costs should not exceed $2,940 per month ($7,000 x 0.42).

Fees and costs

When you refinance your mortgage, just like your initial mortgage application, you’ll have to go through with a home appraisal, credit check, and completion of legal documents. Each of these has associated costs you should be aware of. Your lender, however, may cover many of these expenses, so it’s always best to ask.

How to get started with refinancing your mortgage

To get started with refinancing your mortgage, start with considering the type of refinancing that’s best for you.

If you want to take advantage of lower interest rates, than contact your current lender to find out what the costs would be for ending your mortgage term early. Compare interest rates from different lenders to see if refinancing to save on interest expenses is worthwhile. 

If you’re looking to get a Home Equity Line of Credit, shop around and compare rates from different lenders. Contact each lender to learn more about the details of their HELOC offering.

If you’d prefer to have someone else do the comparison shopping, you can always get in touch with a mortgage broker who’ll work to get you the best rates on your refinancing goals.

Finally, always consider your financial position before deciding to refinance. Make sure you’re doing it for the right reasons and that the benefits of refinancing outweigh the costs.

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