What Is Refinancing? 3 Types of Refinancing Explained

Mortgage refinancing (sometimes called a refi) is a process by which homeowners take out a new mortgage to pay off their existing loan. A mortgage is a contractual agreement between a lender and a borrower that governs a home loan. A standard mortgage agreement requires monthly repayments of the original loan amount plus interest on any unpaid balances.

When a homeowner encounters a new financial situation, they may seek to refinance their current mortgage. They may do so to take advantage of new, lower interest rates or to free up cash to fund a major purchase or home renovation. They may also wish to convert a long-term loan (such as a 30-year mortgage) into a shorter-term loan (such as a 15-year mortgage). The refinancing process requires research and legwork, but it can financially benefit homeowners who follow the process through to its conclusion.

The term “refinance” typically applies to three types of financial maneuvers.

1. 1. Cash-out refinance: Homeowners use a cash-out mortgage refinance to borrow against the value of their current home. To do this, they add to their existing debt by increasing the size of their mortgage. For instance, if they have already paid off $500,000 of an $800,000 mortgage but they want an infusion of cash, they can get a new mortgage that increases their debt. Instead of being $300,000 away from paying off their original loan, they can refinance to owe $400,000, and in doing so, they will get $100,000 in cash (minus closing costs) to spend right away. This type of loan restructuring lets homeowners quickly access cash without taking out a second mortgage.
2. 2. Cash-in refinance: If a homeowner has excess cash they would like to use toward paying off the cost of their house, they can execute a cash-in refinance. Under this refinance option, they can use a large chunk of cash to pay off the premium on their home loan, which should lower their mortgage interest payments going forward. A refinanced loan may be necessary in these cases because the first mortgage may come with a prepayment penalty where the borrower gets charged for paying off the loan too quickly (and thus depriving the lender of interest payments).
3. 3. Rate-and-term refinance: In a rate-and-term refinance, a borrower can change either the length of their mortgage, the terms of their interest rates, or both. When central banks change interest rates, borrowers may find that refinance rates are lower than the interest rates on their current mortgage. In such scenarios, they arrange a rate-and-term refinance with either their current lender or a new lender in order to save money. Another refinancing option is to switch from a 30-year mortgage to a 15-year mortgage, which will require higher monthly payments but less money paid in interest over the course of the loan.

Refinancing your mortgage means you will exchange your current loan with a mortgage lender for a new loan that has its own unique terms and interest rates. Borrowers refinance a mortgage for multiple reasons.

1. 1. To switch to a different type of mortgage: There are two main types of mortgages: adjustable-rate mortgages (ARMs) and fixed-rate mortgages (FRMs), each with its advantages and disadvantages. The interest rates will vary throughout the life of an adjustable-rate loan, while the interest rates will remain the same throughout a fixed-rate loan. Some homeowners start with an ARM that offers interest rates below market value and then refinance their original mortgage into an FRM, which remains the same regardless of fluctuations in the market.
2. 2. To change the length of the mortgage: When a borrower takes out a mortgage, it’s for a certain period—whether a 30-year fixed rate or a 15-year adjustable rate. Sometimes, a borrower may decide to pay off their loan balance in a shorter amount of time to pay less total interest and refinance their mortgage to reduce the mortgage term. In rare cases, borrowers may wish to refinance for a longer-term mortgage to lower their monthly payments and gain upfront monthly savings in the short term. However, stretching the mortgage out will increase the amount of interest they will pay over time. In other words, 30-year loans have lower monthly payments, but they will result in more interest payments over the life of the mortgage.
3. 3. To lower interest rates: Interest rates are calculated as a percentage of the mortgage loan. If a borrower took out a mortgage when interest rates were high or when they had a low credit score, their high-interest debt would end up costing significantly more interest over the life of the loan than debt with low rates. Homeowners may refinance their mortgage to find a new lender who can offer them lower interest rates.
4. 4. To stop paying private mortgage insurance: In cases where a homebuyer pays less than 20 percent of the home value in their down payment, they’re often required to pay for private mortgage insurance (PMI), which helps protect the mortgage lender’s investment if the loan enters default. Once the homeowner has built enough equity in their home, they may choose a refinance loan to cancel their PMI.
5. 5. To draw on home equity: In some cases, homeowners may take out a new mortgage that is larger than their original and use the difference to pay for big-ticket items like a car, a new piece of real estate, home improvements, credit card payments, or tuition payments. This process is called cash-out refinancing and is a form of tapping into a homeowner’s home equity, which is the difference between a home’s current appraised value and the size of its mortgage. Other alternatives to a cash-out refinance include a home equity loan (HEL) or home equity line of credit (HELOC).

Refinancing a mortgage can offer many potential benefits to homeowners. A cash-out refinance can help you tap into the value of your home and free up cash, while a cash-in refinance or a rate-and-term refinance can lower your interest rates and help you pay off the loan in less time. However, the refinance process can also come with disadvantages.

1. 1. Resets the amortization process: Loan payments include two different variables: the principal (or the original loan amount) and the interest (an extra percentage paid on top of the principal). In early monthly mortgage payments, a large proportion goes to interest payments rather than the principal. As the loan matures, these proportions change until the borrower pays more toward the principal and less in interest. Refinancing restarts the amortization curve, which means that the borrower will start the new loan paying more toward interest than principal.
2. 2. Comes with fees: Refinancing can come with several costs depending on the terms of the loans. Closing costs are the most common fees associated with closing a loan and starting a new one. Total closing costs can run between three and six percent of the total loan amount. Other refinancing costs include application fees, credit report fees, origination fees, or prepayment penalties.
3. 3. Can raise interest rates: While the goal of many prospective refinancers is to reduce the interest rates of their current mortgage, refinance rates may not always be lower. If housing market interest rates have risen since the borrower took out their original home mortgage, or if their credit score has decreased, they may find that new lenders will only offer new mortgages with higher interest rates.

To understand how refinancing works in the real world, consider these three examples.

1. 1. Rate-and-term refinancing example: A homeowner switches from a 30-year loan with a 4.8% interest rate to a 15-year loan with a 4.15% interest rate. The homeowner's monthly payments will increase, but the total value of the mortgage will be paid off sooner, and they will spend less total money on interest payments thanks to the lower rate.
2. 2. Cash-out refinancing example: A homeowner who has $250,000 left on their original mortgage decides to refinance and borrow more money at a lower interest rate. They ramp up their borrowing to $325,000. This gives them $75,000 in cash (minus closing costs) to handle other financial matters, like doing home repairs or paying off credit card debt.
3. 3. Cash-in refinancing example: A homeowner receives a $50,000 year-end bonus from their job. They would like to spend that money on paying down their current mortgage, but it comes with a prepayment penalty. To manage this reality, the homeowner takes out a new mortgage that allows them to immediately use the $50,000 to pay down their principal. They will now owe less money and spend less in interest payments going forward.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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