How Mortgage Refinancing Works?

Mortgage refinance is a procedure in which the borrower approaches a lender to get his existing mortgage paid-off. While the lender pays it off, he also grants the borrower a new mortgage for a different interest rate and term. The reason a borrower would want to go for a refinance is – a) to take advantage of the new lesser interest rate or b) to cash in on the equity which has accrued on the real estate.

In both the cases, the borrower is trading the old loan for a newer one that has more attractive interest rate and term, and possibly, a new balance. The borrower can even choose the same old financial institute or bank to refinance his mortgage. However, borrowers usually look out for a fresh lender in the mortgage industry. The ideal reason for this could either be the existing lender’s reluctance to refinance or as it happens, borrowers generally find a better deal with other lenders who attract them with special offers.

There are essentially two types of mortgage refinancing. One is Cash-out refinancing, and the other is Rate and term refinancing.

Cash-out refinance

In this option, a borrower with a mortgaged home decides to pull out the cash from the existing loan. The most likely reason for this could either be to take advantage of the lowered interest rates. Although the borrowers can opt for refinance on their mortgage to tap into their home equity. There could be several reasons for this, which could range from buying another property, purchase of luxuries, investment in stocks, etc., to using it for emergency situations like health issues. The two methods a borrower can utilize the home equity include – opening a Home Equity Line of Credit (HELOC) behind their first loan, or get their loan refinanced and take away the cash. To put things simpler, let’s consider an example.

In HELOC, the rate of interest and term do not change, so its not exactly a Cash-out refinance.

Let’s assume a home owner ‘X who has a house that is valued at $100,000. X has already paid $40,000 in monthly installments, which is now the equity accrued on the house. This simply means, X owns $40,000 of the house. The balance mortgage is $60,000, which is also called existing lien.

Now from the two options X chooses HELOC of $30,000. This leaves the rest $10,000 in equity. With this the balance increases to $90,000. Now X has two loans. First is the original $60,000 and the second is the $30,000. Usually both have the same interest rate and term.

If X chooses the cash-out refinance, he now gets his existing mortgage of $60,000 to refinance and takes $30,000 out from the equity. This now create a new mortgage of $90,000.

The sole dissimilarity is that X is still left with a single loan, which will now have a new interest rate and term. Also, X would most likely opt for a different financer or lender to refinance the mortgage. This way X could enjoy the lesser interest rates and terms for the refinanced mortgage amount.

Rate and Term Refinancing

This is rather simple as a borrower simply opts for much more attractive rate and terms to finance the original mortgage amount, irrespective of equity accrued.

For example, X has a mortgage loan of $ 100,000. The original interest rate of the finance is 5% and the term is 30-year fixed. X now get it refinanced for 4% and with a term of 15-year fixed. This is essentially Rate and Term Refinancing is about, and there is no option for a Cash-out.

While many would want to use mortgage refinancing to save on monthly installments on their loan by taking advantage of better rate and term, it is usually not for all. Excellent credit score is usually the main criteria used by lenders to determine who can be offered these advantages. However, anyone can opt for second mortgage, probably the home equity line of credit. This way they can keep their first mortgage intact, while also tap into their home equity whenever the need it.

Key Takeaways

• Mortgage Refinance is a procedure through which borrower pays off the old mortgage and gets the newer one refinanced at a different rate and term.
• In Cash-out refinance, a borrower with a mortgaged home decides to pull out the cash from the existing loan.
• In Rate and Term refinance, a borrower simply opts for much more attractive rate and terms to finance the original mortgage amount.