All About Mortgage Refinancing: Pros and Cons of Refinancing

A mortgage is a loan that home buyers take out from a bank, credit union, or other mortgage lenders to pay for a home or other piece of property. When a home buyer takes out a mortgage loan, they put the real estate up as collateral and make monthly payments to secure property ownership.

Mortgage refinancing (sometimes called a refi) is a process by which homeowners take out a new mortgage to pay off their existing one, usually to adjust the interest rates or terms, or fund a major purchase or home renovation.

While refinancing can help homeowners tap equity, secure a reduced interest rate, change the loan’s lifespan, or finance a big purchase, it has a few disadvantages. Refinancing a mortgage can reset the amortization process, which means that buyers will pay more interest than principal at the start of the new loan. Lower credit scores or a change in the housing market can result in higher interest rates on the new mortgage loan.

In general, here’s a step-by-step overview of the mortgage refinancing process:

1. 1. Loan evaluation and goal establishment. A few different reasons a homeowner may want to refinance are mortgage interest rate reductions, switching to another type of mortgage, or home renovations. For homeowners, the first step in the refinance process is to evaluate the current mortgage loan and identify their financial goals before moving forward.
2. 2. Find the best lender. Once borrowers identify their goals, they’ll search for lenders that can offer them the right mortgage for their situation. Prospective refinancers may apply for multiple loans with different mortgage lenders and then compare the estimates using an online mortgage calculator to determine an ideal break-even point.
3. 3. Close on the loan. After the borrower finds the lender with the best loan terms for their needs, they will close on the new loan, sign documents, and pay any necessary closing costs.
4. 4. Pay off the original mortgage. With the money from the new refinance loan, the borrower will pay off their original mortgage. If they applied for a new loan that is larger than their initial loan, they keep the difference and use it to achieve their goals.

Here are some of the most common factors that lead a homeowner to consider refinancing:

1. 1. 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.
2. 2. 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 ARM, while the interest rates will remain the same throughout an FRM. Some homeowners start with an ARM that offers interest rates below market value and then refinance their loan into an FRM, which remains the same regardless of fluctuations in the market.
3. 3. 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 monthly payments for upfront monthly savings in the shorter period. However, stretching the mortgage out will increase the amount of interest they will pay over time.
4. 4. 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).
5. 5. 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 to refinance their loan to cancel their PMI.

A mortgage refinance can come with a few drawbacks:

• 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 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.
• 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.
• 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.

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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