As mortgage rates continue to stay low, many homeowners are giving thoughtful consideration to refinancing–the process of replacing an existing mortgage with a new one, usually giving the homeowner a more affordable rate or more favorable terms. While refinancing a mortgage may not make sense for every homeowner at this time, current market conditions may make it a worthwhile endeavor. In today’s post we’ll cover mortgage refinancing basics and look at the most common benefits.
Basics of Mortgage Refinancing
When you buy a home with a mortgage, you are agreeing to pay the loan back at a certain rate of interest over a certain period of time. Depending on when you took out your mortgage and what your financial picture looked like at that time, you may have ended up with a rate and/or terms that are no longer the most beneficial to your situation. It’s not uncommon for homeowners to “outgrow” their mortgage, so-to-speak, as life circumstances and household finances naturally change.
Here are the basic concepts of refinancing a mortgage:
- The homeowner applies for a new mortgage to pay off and replace an existing mortgage, usually with a lower interest rate or better terms.
- The homeowner usually has to have at least 20% equity in their home in order to qualify for a mortgage refinance; however, different loan guidelines may have different or additional requirements.
- Once the homeowner’s application is approved and the refinance is complete, the homeowner now is only responsible for the new loan, essentially wiping the slate clean of the old one.
- In some scenarios, this will mean the homeowner is “starting over” or “resetting” their mortgage. This can be avoided if the homeowner makes a larger down payment or refinances into a shorter-term loan than their original (e.g., refinancing a 30 year loan to a 15 or 20 year loan.)
Refinancing gives homeowners the opportunity to improve their home loan conditions in several ways, but the majority of homeowners choose to refinance for the sake of securing a lower interest rate. This usually means their new loan will have a lower monthly payment, helping the homeowner save money every month.
There are other reasons a homeowner may choose to refinance, from shortening their loan term to getting cash from their equity.
Shorter Loan Terms
As we mentioned above, if you choose to refinance into a shorter-term mortgage, you will have the opportunity to build equity faster and pay off the loan sooner. The downside to this is that you could end up with higher monthly mortgage payments, even if the interest rate is lower. This is because of amortization, the structure in which most conventional mortgages are set up.
Through amortization, a certain portion of every monthly mortgage payment goes toward paying back the loan (principal) and the rest goes toward paying off the interest. The amount that goes toward each component changes over time, with more of your monthly payment going toward interest in the beginning and slowly decreasing over time. If you refinance into a shorter-term mortgage, the amortization process happens faster, with more of your payment going toward principal more quickly.
Another reason some homeowners choose to refinance is to draw cash from their equity. If you own a home that has built up a substantial amount of equity and you are in need of cash, the cash out refinance option could be an ideal solution. In this scenario, a homeowner refinances their current mortgage for more than what they owe and receives the difference in cash.
Because the money can be used for anything the homeowner wants, cash out refinancing is popular among homeowners who may need to fund a large expense but don’t want to open a new line of credit. After all, most credit cards have fairly high interest rates (the average is around 20.00%, according to WalletHub), while mortgages tend to have significantly lower interest rates (conventional 30-year mortgage rates recently averaged around 4.00%, according to the Mortgage Bankers Association.)
For homeowners who have government-backed loans such as VA mortgages or FHA loans, there are streamline refinancing opportunities available, allowing the process to move fairly quickly. The reason why these loans are considered streamlined is because the homeowner is moving from one VA loan to another VA loan or from one FHA, USDA, etc. loan to another. Typically no additional appraisals are required for these streamline options and some do not require income or employment verification.
For example, the VA has the VA Interest Rate Reduction Refinance Loan (IRRRL) program, which doesn’t require an appraisal, income or employment verification, credit report or termite inspection as long as the homeowner has a current VA mortgage and it has been paid on time for the last 12 months.
Likewise, the FHA Streamline refinancing program does not require an appraisal or income or employment verification, but the homeowner must be a current FHA borrower, have a FICO score of 620 or higher (some lenders may require 640 or higher) and the mortgage must be up to date for the last 12 months.
There is also a streamline refinance option for USDA mortgages. Well, technically there are two USDA streamline refinance options: the USDA Streamlined-Assist and the Standard USDA Streamline. Both are designed to help homeowners have more favorable USDA loan terms/rates, but the main difference is that the Streamlined-Assist option does not require income verification while the standard USDA Streamline refinance requires proof of current income and the homeowner must meet certain debt-to-income standards.
Disclaimer: The statements above are intended to provide a general overview of the VA, USDA and FHA streamline refinancing processes and do not provide fully comprehensive loan guidelines or eligibility requirements. Other restrictions or requirements may apply. Speak with your mortgage lender for details.