If you’re not in the industry, you might not be exactly sure what refinancing entails, what it actually means and why you should or should not be considering it.
Let’s go through this together and learn what it means to refinance your mortgage and if it makes sense for you.
Refinancing a house is the process of paying out your existing mortgage with a new mortgage. Why? Well, it may (not necessarily) have better a better rate and terms. Or you may need extra money to consolidate some debt or other important purchases and
If you have lots of unsecured debt, there is no faster way to improve your cash flow and get some relief.
However, refinancing can also work against you and become a nightmare if you are not careful about it.
Refinancing can make sense if interest rates have fallen. Or do you expect them to go up and want to lock in at the lower rates for a longer term. Perhaps your credit score improved enough so that you might be eligible for a lower-rate mortgage. Maybe you would you like to switch into a different type of mortgage. How about consolidating some high interest debt or you may require some funds for renovations, child’s education, etc. All good reasons to have a look at refinancing.
How Does Refinancing Work?
Refinancing process involves many of the same steps you took for the home buying process.
But you decide, you need to assess what is involved. Your home may be your most valuable financial asset, so you want to be careful when choosing a lender or broker and specific mortgage terms. Remember that, along with the potential benefits to refinancing, there are also costs.
Refinancing pays off your existing mortgage and creates a new one in most instances. You can even choose to combine a first and second mortgage together.
Main thing for me is to calculate your break-even period. After calculating your break-even period, you may want to get more detailed information. Will you break even from day one? Likely not. But you should at least know that by the end of your current term, that you will be ahead of the game and by how much through your refinancing.
A general rule of thumb is that you should have at least 20% equity in your home if you want to refinance. Yes, there are options to exceed this amount, but they will become expensive.
Mortgage Refinance Options
Everyone will have their own reason(s) to refinance. However, if you have made the decision to explore this, then what type of refinancing should you choose? There are a few options.
Refinancing with your current lender – This option may not necessarily avoid a penalty to pay your mortgage off early, but it can reduce the penalty. The penalty may even be avoided if the lender can add to the existing mortgage with a separate mortgage loan or component rather than breaking the existing mortgage.
Blend an extend with your current lender – This is designed to avoid penalty. Instead of paying the penalty, you might combine your current mortgage rate with the new mortgage rate for a new fixed term at a rate that is somewhere between your current rate and the going rate today. Thus, in addition to “blending” the two rates, you were also able to keep your mortgage from needing to be refinanced and avoid paying a penalty. The blended rate would be calculated proportionately factoring existing rate and balance vs. new rate and new money and proposed new term
Blend to term – Same as above but you don’t extend your mortgage term. Simply, you are blending the interest rate on current amount owing with prevailing rate for the new money. Not very common and not available with many lenders.
Refinancing with your current lender before the end of your term – Sometimes it can be better to take your lumps, pay a penalty and start fresh. This involves some math and comparing scenarios. However, if it does pay off to break your mortgage and your current lender is in the game as far as competitive rates, then this scenario may work for you.
Refinancing with a different lender before the end of your term: Same as above. However, your current lender was not as competitive, and you are moving your business for better rates, terms, and conditions.
Home Equity Line of Credit (HELOC) – If you want to access the equity in your home on an as-needed basis, you could take out a home equity line of credit (HELOC) instead. With a HELOC, you wouldn’t get a lump sum of cash, but could instead access funds through a revolving line of credit. This would be a separate product and not touch your existing mortgage. Typically, pay interest only on what you owe, fully open.
Second Mortgage – A second mortgage is different from a mortgage refinance. If you obtain a second mortgage, this will be an additional loan and a separate payment to your list of monthly obligations.
So, you will still be paying your original mortgage as well as another payment to the second lender. Whereas, when you refinance, you pay off your original loan and replace it with a new set of loan terms as above.
You will have to pay a higher interest rate on a second mortgage than a refinance because the second mortgage lender is taking on increased risk.
How To Refinance A Mortgage
First, see if a mortgage refinance is right for you, and check for best alternatives available. If you’re refinancing to get a lower interest rate, check to see if your interest savings would be more than any mortgage penalties that you would have to pay. You need to know your break even after penalty and all costs. Also remember, If you’re looking to borrow additional money, your refinanced mortgage can’t be greater than 80% of your home value.
If you have determined refinancing is right for you, shop around with different mortgage lenders and mortgage brokers. You do not have to refinance and stay with your current mortgage lender. Other lenders may offer lower mortgage refinance rates than your current lender. However, switching lenders can come with extra costs so the savings must be worth it.
Refinancing your mortgage and applying for a new mortgage are very similar. You’ll need to have your pay stubs, tax returns, and statements to provide to your lender. You’ll need to pass the mortgage stress test at your new refinanced mortgage balance, and you will also need to have a home appraisal conducted.
The first step is to reach out to your mortgage lender and a few others to compare pricing and discuss your options. Most lenders will require a simple application for you to get approved for the mortgage refinance as well as your supporting documents.
Mortgage underwriters will then evaluate the application. While the application is being considered, your lender will arrange a home appraisal by a licensed appraiser to determine the home’s market value.
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Reasons To Refinance Your Mortgage
- Lower monthly mortgage payment amount
- Consolidate credit card debt
- Home improvements
- Lower interest rate
- Shorten the mortgage term, pay off period
- Convert from an adjustable-rate mortgage (ARM), variable rate mortgage (VRM) to a fixed-rate mortgage, or vice versa
Questions To Ask
- What type of mortgage is it—fixed- rate, adjustable-rate, interest only, other?
- What is the loan term (length of loan)?
- What is the annual percentage rate?
- Can the balance you owe on the loan rise?
- Does the loan payment include principal and interest?
- What is the estimated total monthly payment (principal, interest,)?
- What are the estimated fees and other closing costs?
- Does this loan have a prepayment penalty? If so, how much could it be?
- If the loan has an adjustable rate, how is this calculated and adjusted?
- What is the most the rate could be during the term?
- What is the most the monthly payments (for principal and interest) could be over the life of the loan?
- What happens at renewal? What are costs if any
What will refinancing cost?
It is not unusual to pay lender fees, brokerage fees, appraisal fees and legal fees when refinancing. These expenses are in addition to any prepayment penalties or other costs for paying off any mortgages you might have.
Refinancing fees vary from province to province and lender to lender. Here are some typical fees you are most likely to pay when refinancing (Note that not all fees apply to each situation).
- Application fee. Some lenders charge for processing your application and checking your credit. Some retain this fee whether or not your loan is approved or declined. Not common with most lenders or brokers.
- Lender fee. The fee charged by the lender. Usually on non-traditional, non-qualified, private, and commercial loans. It is a lending fee over and above the interest rate being charged.
- Brokerage fee. The fee charged by your mortgage broker to arrange your mortgage loan. Not always applicable.
- Appraisal fee. This fee pays for an appraisal of your home, in order to assure the lenders that the property is worth at least as much as the estimated value. Some lenders and brokers include the appraisal fee at no charge.
- Inspection fee. In some situations, the lender may request a report by a property inspector, engineer, or consultant to ensure the property is in good state of repair. Lenders may require a septic system test and a water test to make sure the well and water system will maintain an adequate supply of water for the house.
- Legal Fees. There will usually (not always) be fees paid to the lawyer or company that conducts the closing for the lender. Sometimes, especially with private lenders, there are two lawyers involved in the closing.
- Title search and title insurance. This is the cost of checking the property’s history to ensure that you are or will be the rightful owner and to check for liens, or other issues. Title insurance covers you and the lender against errors or issues with title now and in future. If there is a problem later, a claim can be made against the title insurance company by you or your lender.
- Prepayment penalty. If you pay your mortgage off prior to the maturity date, a pre-payment penalty may apply.
What is “no-cost” refinancing?
This means different things to different lenders. So, “no-cost” refinancing is not always what it seems. Specific terms are offered by each lender differently. There are two basic ways to avoid paying up-front fees.
One is where the lender will cover the closing costs, but usually in exchange for a higher interest rate. You will pay this higher rate for the life of the loan.
The second is when the lender includes or rolls in the refinancing fees into the new mortgage. They become part of the amount of the mortgage. While you will not be required to pay cash up front, you will instead end up repaying these fees with interest over the life of your loan.
How do you calculate the break- even period?
Not very scientific, but it keeps things simple. The guide below can help give you a ballpark estimate of how long it will take to recover your refinancing costs before you breakeven from refinancing. The example assumes a $200,000, 5 year fixed-rate mortgage at 3% and a current loan at 5%. This assumes fees for the new loan are $2,500.
- Your current monthly mortgage payment $1,163.91
- Subtract your new monthly payment $ 946.49
- This equals your monthly savings $ 217.42
- Total of your new loan’s fees and closing costs $2,500.00
- Divide total costs by your monthly savings $2,500 / 217.42
- This is the number of months it will take you to recover your refinancing costs. 11½ months
Remember, you must include ALL fees in your calculations. However, if you are also consolidating debt, you must factor in your savings on the debt vs. how much longer (or shorter) it may take you to pay out the debt compared to your present pay back arrangements.
If you plan to stay in the house until you pay off the mortgage, you may also want to look at the total interest you will pay under both the old and new loans.
Your amortization may (likely) change as well. So, this must be factored into your decision. If you have 15.2 years left to pay your mortgage to zero and your new loan is bringing that back up to 25 years, big difference. Big.
Last But Not Least – Our Friendly Advice
Refinancing can be a great choice. Especially if it can reduce your mortgage payment (cash flow), reduce the term of your loan, and can help you build equity quicker. When used carefully, it can also be a valuable tool for managing your debt and eliminating nasty high interest debt. What is your financial situation? Ask yourself how long do you see yourself living at this property? How much money will I save by refinancing and when is my breakeven?
It could take months or years to recoup costs with the savings generated by a lower interest rate or a shorter term. So, the cost of refinancing may negate any of the potential savings.
You should “always” look for ways to reduce debt, build equity, save money, and eliminate your mortgage payment. Taking cash out of your equity when you refinance does not help to achieve any of those goals. Unless, that cash has a well thought out, mathematically calculated purpose that will put you in a better situation that you are in today.
Lou A Salvino
