Refinancing Your Home

Refinancing Your Home

Home refinancing, or refinancing the existing mortgage on a home, is a very common practice. This is especially true in times of falling interest rates when home owners are looking to refinance to obtain a lower interest rate and monthly payment than their existing mortgage. There are many motivations for refinancing a home, the most common of which are listed below.

Rate Refinancing

Rate refinancing is refinancing to obtain a lower interest rate than the home owner currently has with their existing mortgage. This will result in a lower monthly payment of principal and interest than the home owner's existing mortgage and less interest paid over the life of the loan.

When refinancing to obtain a new interest rate, a home owner may or may not elect to change the term of their loan (the amount of time necessary to pay off the loan). For example, if a home owner was refinancing an existing mortgage that they have had for five years, they may elect to take out the new mortgage with a lower rate and a 25 year term. In this case, they would pay off their loan at the same time as the previous loan. They would simply have a lower interest rate and monthly payment and pay less interest over the life of the loan than they would have if they had not elected to refinance.

Term Refinancing

Another strong motivation for refinancing a home is to change the term of the existing loan. This may or may not necessarily be done to obtain a new interest rate at the same time. In one scenario, a home owner may elect tor refinance a home to spread their principal payments over a longer amount of time. For example, a home owner with 20 years left on their existing mortgage may elect to refinance into a new 30 year mortgage. In this case, the remaining principal balance on their loan would now be amortized over thirty years instead of the 20 years for their previous loan. Assuming that there is not an appreciable change in their interest rate, this would result in a lower monthly payment.

Another common reason for a term refinance is to shorten the term over which a loan will be paid so that the home owner pays off their mortgage and owns their home more quickly. It is very common for home owners to refinance the remaining portion of a 30 year mortgage with a new 15 year mortgage. This, of course, only makes sense if the home owner has 20 or more years remaining on their existing loan. In this scenario, while the home owner will most likely obtain a lower interest rate, their monthly payments will increase because of the more accelerated amortization (payoff) schedule. Even though their monthly payment will go up, the amount of interest that they will pay over the life of the new loan will be substantially less than their previous mortgage would have been.

Rate and Term Refinancing

Rate and term refinancing is a combination of the previous two motivations. In this case the home owner is both obtaining a new (typically lower) interest rate as well as changing the term over which they repay the loan. They many extend the term over their existing mortgage to obtain even a lower monthly payment, or they may elect to shorten the term so that they own their home more quickly.

Cash-Out Refinancing

Another strong motivation for refinancing a home is to obtain cash from the equity a home owner has built up in their home. Equity in a home increases as a home owner pays off principal, as the home appreciates in value, or both. There are many reasons why a home owner may want to tap into the equity of their home to obtain cash, including:

  • They need money for home repairs, renovations, remodeling, or expansion
  • They need money for another significant purchase (e.g., purchase a second home, purchase a car, pay for a wedding, travel, etc.)
  • They need money to pay off other debt such as student loans, or credit card debt

There is risk to cash out refinancing. It works well as long as the housing market is strong and the value of a home continues to appreciate. If there is a downturn in the housing market and house prices decline, the home owner could end up in a situation where they owe more for their mortgage than their home is worth. This situation may not have arisen if they had not tapped into the equity in their home. In such a situation, if the home owner had to sell their home for any reason such as job relocation, they would have to pay additional money to the lender to meet their mortgage obligation.

Mortgages to Refinance a Home

Two types of mortgages are used overwhelmingly for home refinancing. Fixed rate mortgages are the most common mortgage vehicle for refinancing a home. There are two reasons for this:

  1. Most borrowers are predisposed to fixed rate mortgages because of their payment predictability
  2. Fixed rate mortgages are very commonly used to refinance existing adjustable rate mortgages in times of declining interest rates to obtain both a good rate and payment predictability

Adjustable rate mortgages are the second most commonly used mortgage type for refinancing a home. Their popularity stems from the fact that at any given point in time they typically have the lowest interest rates.

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