When you decide to pay off an existing loan with a new one, it is known as a refinance. There are several motivations to opt for a refinance, such as getting a lower interest rate or reducing the mortgage term. Borrowers can refinance all types of loans, including home loans.
So, what does refinance mean in the context of home loans? Here’s everything you should know:
What Is a Home Loan Refinance and How Is It Used?
When you refinance a home loan, you take out a new loan to replace your existing one. The new loan is used to fully pay the balance on the original loan and going forward, your monthly payments go toward repaying the new loan.
The process of home loan refinance is similar to taking out a mortgage. The borrower can approach either their existing lender or a new one and complete an application. To approve the loan, the refinance lender considers several factors, including the current value of your home, the equity you hold in it, your income status, your debt-to-income ratio, and your credit history. A higher credit score increases your chances of getting a home to refinance at favorable terms.
Similar to a regular mortgage, there are costs involved in refinancing a loan. Application fees, origination fees, and processing fees are usually paid out of pocket, but sometimes, they can be rolled into the loan.
You also need to pay for the appraisal that verifies the value of your home before the lender greenlights the refinancing request. If you roll over the fees into the loan, the total amount gets deducted from the refinanced amount. Make sure to factor closing costs and the breakeven point into your refinancing plan.
Homeowners refinance primarily to enjoy a reduced interest rate or to access home equity with an option called a cash-out to refinance. It is also possible to change the term of your mortgage through a home loan refinance, resulting in lower repayment installments or lower overall interest charges.
Here are some of the top reasons why homeowners decide to take out a refinance loan:
1. Pay a Lower Interest Rate
One of the most common reasons for a refinance is to lower the interest rate. This is known as a rate-and-term refinance loan. A lower rate means you pay less for your monthly payment. It also means you pay less interest over the life of the loan. The lower interest rate can be the result of changing market conditions or an improvement in your personal financial situation since you first took out the loan.
2. Change the Term of Your Existing Loan
Using a home loan refinance, you can change the term of your loan from 30 years to 15 or 10 years or vice versa. Lengthening the term can help you lower the monthly payment, as you’re spreading your current loan balance out over a longer repayment period.
Note that this also means that the total interest paid over the entire length of the loan will be higher, maybe more than what you save through a lower interest rate. But if you’re struggling to make monthly payments, this option could help.
If you refinance to shorten the loan term, you will be able to pay off your loan sooner. This means you save on interest over the life of the loan. Though, you will likely pay a higher monthly payment.
3. Obtain Cash From the Equity of Your House
Home refinance is also an attractive option for borrowers with significant home equity. They can use a cash-out refinance to tap into the equity. The equity gets converted into cash, which can be used for consolidating existing debt or financing a purchase. More on this in a minute.
4. Modify the Interest Rate Type
If the original home loan is an adjustable-rate mortgage (ARM), you can refinance to convert it to a fixed-rate mortgage. Doing so can insulate you against fluctuations in the market. You can also convert to an ARM from a fixed rate as a way to access the lower introductory interest rate of an ARM. This may be a valid option if you plan to move very soon and want to save on interest in the interim.
What Is a Cash-Out Refinance?
A cash-out refinance is a popular refinance option. It allows you to take out a bigger mortgage than you currently have by borrowing additional funds from your home’s equity. The difference between your loan balance and the amount of the new loan is paid to you in cash, which can be spent as you like.
This option requires that you have built up equity in your home. This mainly happens as you make your monthly mortgage payments, but the equity can also increase if the value of your home increases.
Typically, a cash-out refinance allows you to borrow up to 80 percent of your home’s value, though experts recommend borrowing only what you need. The amount available is determined based on home appraisal, and you must own at least 20 percent of the home equity.
To evaluate your loan application, lenders consider several factors, such as your credit score and debt-to-income ratio. Unless you have received the house by inheritance, many lenders require you to own it for at least six months before applying for a cash-out refinance.
The major attraction of cash-out refinances is the availability of a large sum of cash that can be used for large expenses, such as consolidating debt or paying for home renovations. Instead of taking out a second mortgage on your house—a home equity loan—, you can opt for a cash-out refinance that leaves you with a single mortgage to manage.
Borrowers can still receive a better interest rate or change the term of their loan with a cash-out refinance, adding to the benefit.
A home loan refinance can be a good idea if you want to lower your interest rate, change your loan term, or access your home equity. Consider the pros and cons carefully to determine if it’s the right option for you.
To discuss your refinance options or learn more about the question of what does refinance mean, reach out to the home loan experts at Solarity Credit Union. They’ll answer your questions and be there through every step of the process.