What Is Refinancing?

Many homeowners enjoy refinancing opportunities to take advantage of new interest rates and better deals. This article looks at what refinancing is, its pros and cons, and how it works.

What Does Refinance Mean?

Refinance, also known as “refi,” refers to taking a new loan to repay an existing one. The new loan may have different terms than the existing loan, such as a different interest rate, loan amount, or repayment period.

Borrowers also refinance to consolidate multiple debts into one payment or to free up cash. The loans which are often refinanced include credit cards, car loans, mortgage loans, student loans, and small business loans.

Here is refinance’s meaning with an example.

Let’s say you have a $10,000 loan with an interest rate of 6%. If you refinance a new loan with an interest rate of 4%, you could save $200 per year in interest payments. And if you refinance to a shorter loan term, you could save even more money in interest payments.

Hopefully, the above example answers the question of “what does refinancing a loan mean”?

How Refinancing Works?

Your lender will pay off the old loan when the new one is due. This will leave you with the latest loan, on which you will use the new interest rates and monthly principal for payments.

You can refinance with a new lender if you find one with better terms than the current one. You can still refinance with the current lender if you are satisfied with the terms.

When refinancing, you must go through the loan application process again. You will probably need to meet certain minimum requirements to refinance your mortgage. These include debt-to-income ratio, good credit score, enough home equity, and good standing with the loan you’re refinancing.

Furthermore, they will want proof that you’ve paid off other debts like car loans or personal loans from the past few years. Checking with multiple lenders will help you understand whether you’ll qualify for different types of refinancing. This will also give you a clearer picture of which lender works best for your current situation.

Types of Refinancing

There are different types of refinancing available to borrowers. Each has its positives and negatives, so it’s crucial to pick the right one for your needs.

Rate-and-term refinancing: This type of refinancing replaces your existing loan with a new one which might offer a lower interest rate and/or a different loan term. The rate-and-term refinancing is the most common refinancing type.
Cash-out refinancing: This type allows you to tap into the equity you’ve built up in your home. Here you can take out a new loan that exceeds what you owe on your current one. For example, if the value of your underlying asset has increased and you want to cash out on its equity portion. Let’s say your current mortgage is $300,000, and you want $30,000 cash when refinancing. Taking a cash-out refinancing will increase your mortgage by $330,000. When the process is successful, you will receive $30,000, which will be tax-free.
Cash-in refinancing: In cash-in referencing, a borrower pays a certain amount of money during refinancing to reduce the loan amount. As a result, the new loan might come with a lower interest rate and a reduced repayment period.
Consolidation financing: You can use consolidation refinancing to merge multiple loans into a new loan with a lower interest rate.
Streamline refinancing: This type of refinancing is available to those with a government-backed loan, such as a Federal Housing Administration (FHA) loan. Streamline refinancing helps homeowners reduce interest rates and monthly payments.

Pros and Cons of Refinancing

Refinancing is a big decision, and it’s not one you should take lightly. It has a good side and a bad one. So, weigh the pros and cons carefully before you make a decision. Here are some things to guide you:

Benefits of Refinancing

1. Lower Monthly payments

Lowering your monthly payments is one of the top reasons for refinancing. You can refinance to get a lower rate if the ones you have decreased since you first took out your mortgage. This can save you a significant amount of money each month.

2. Shorter Loan Term

Refinancing allows you to shorten your loan term. For instance, if you have a 30-year loan, you can refinance it to a 15, 10, or 20-year loan. This will increase your monthly payments but lowers the interest in the long run.

3. Consolidate Multiple Loans

Combining multiple loans can help you get lower interest rates. It’s also easier to manage one loan coming from a single lender.

4. Extend Repayment Period

Refinancing can help extend the length of your loan. This can be useful if your income has decreased and the monthly payment is high, becoming a challenge. However, this could mean you will pay more interest difference in the long run.

5. Change from Adjustable Interest Rate to Fixed Interest Rate

Adjustable interest rates may be unpredictable since they can increase or decrease without notice. Switching to fixed rates may lead to lower interest rates in the long run. However, you may be charged for breaking the contract.

6. Allows You to Adjust the Information on the Current Contract

Refinancing gives you a chance to update details in your contract. Here you can add or remove co-borrowers or cosigners, for example, a spouse.

Drawbacks of Refinancing

Although refinancing has numerous advantages, it also has its downside. Here are the biggest potential drawbacks of refinancing your home:

1. Paying More in Interest over the Long Term

When you refinance, you may get a lower interest rate. However, you can pay more interest over time if you prolong the loan’s term. So, it’s important to consider how a lower interest rate will impact your overall financial picture before you decide to refinance.

2. Pay Fees to Refinance

Refinancing comes with closing costs, including origination fees, appraisal fees, inspection fees, and attorney fees. Depending on your lender, refinancing could result in closing charges of 3% to 6% of the new loan amount.

3. Refinancing Can Affect Your Credit Score

The banker will first perform a hard inquiry on your credit record when you apply for the loan. This hard inquiry can slightly reduce your credit score by a few points.

4. Payment of Lenders’ Mortgage Insurance

If you want to refinance your mortgage, you may have to pay mortgage insurance to your new lender. Lender mortgage insurance (LMI) is typically required if you have less than 20% equity in your home. So, if you are refinancing to get lower rates, you may have to pay mortgage insurance, which can offset some savings you were hoping to get from refinancing.

How to Refinance?

Here are some refinancing steps that can help make the process easy and help you land the best offer:

1. Check Your Credit Score

To get the best deal, your credit score should be impressive enough. Each lender and loan type has different requirements, but a good score will warrant lower interest rates. Furthermore, a high score increases the chance of lenders approving your loan.

2. Prepare other requirements

After ensuring that your credit score is good, consider other requirements your potential lender might need. This will depend on the type of loan you are applying for. If you’re refinancing your mortgage, ensure to determine your home’s equity. Having at least 20% equity is a great start—you might not even pay for LMI. Furthermore, ensure you have a verifiable income and a low debt-to-income ratio.

3. Do Thorough Research

Now that you’ve made sure you have most of the requirements; it is time to do thorough research. You’ll need to shop around to find the best refinance rates. This means getting quotes from multiple lenders and comparing them side by side. Make sure to compare rates, fees, and terms to find the best deal.

In addition, remember to get an offer from your current lender. If their offer is better than others, you might save some costs; although it’s most likely, you’ll get lower rates from new lenders.

4. Prepare Your Documents

You may need to prepare documents like your tax returns, pay stubs, and bank statements. These documents will be used to verify your income and assets.

5. Loan Application

Next, you’ll need to apply for a loan. This process is similar to when you applied for your original mortgage. You’ll go through a credit check and provide information about your employment and finances. Your lender will be interested in your net worth, so disclosing all information upfront is important to make the process easier.

6. Be Ready for the Appraisal

In most cases, lenders will require a home appraisal to determine your home’s value. Be ready to pay for the charges.

7. Close the Loan

The last step is to pay the closing fees. Note that depending on the lender, it’s possible to roll the closing cost in the loan amount. However, this means you will pay interest on this cost which slightly increases the interest rate.

Should I Refinance?

Refinancing your loan can be a major way to save money on your loan. You can lower your monthly payments and repay your loan faster by getting a lower interest rate. You can also use refinancing to access the equity in your home and get cash for home improvements or other expenses.

However, refinancing is only right for some. You should carefully consider your financial situation before you decide to refinance your mortgage.

Here is some indication that you should not refinance your loan:

You cannot access lower interest rates.
There will be a struggle to afford the refinancing costs.
You have a long break-even period.
It doesn’t shorten the loan term.

How Long Does It Take to Refinance?

Refinancing can take anywhere from 30 to 40 days. However, it all depends on the lender you choose and the type of loan you’re getting. The best way to find the exact time is to speak with your lender. They are better positioned to give you a more accurate timeline based on your specific situation.

What Does It Mean to Refinance a Loan?

When you refinance a loan, you take a new loan to replace an existing one. The new loan will have terms and conditions different from your current loan, and it may have a lower interest rate, monthly payment, or a different repayment schedule.