Higher interest rates can make buying a home with a mortgage loan more expensive. However, homebuyers can change their interest rates down the line through refinancing. When interest rates lower, owners can borrow their outstanding debt at a lower market rate, affecting their monthly payments to quickly achieve their financial goals. Refinancing also allows borrowers to reconfigure their loan terms.
What Does Refinance Mean?
Refinance refers to the process of paying off existing debt using funds from a new type of financing, usually another loan or line of credit. Borrowers receive the funds from their new loan to pay off the primary loan and will then work toward paying off the secondary debt with more appealing terms.
When you refinance, you’ll have the option to change the terms of the original loan to achieve specific financial objectives, such as lowering your interest rate or monthly payment. You may also want to pay off a portion of the loan’s principal balance to lower the total amount of outstanding debt.
What is Refinancing a Mortgage Loan?
Refinancing a mortgage allows borrowers to pay off and replace their existing home loan with a more favorable borrowing arrangement. Borrowers may use the new loan’s proceeds to pay off their existing mortgage. In addition to securing a lower interest rate, refinancing a loan balance for a new loan with a shorter term can help you pay off your home faster and own the property free and clear.
Depending on your current mortgage terms and financial goals, you may refinance a loan for various reasons.
Lower Interest Rate
Lower refinance rates benefit borrowers by reducing the total amount they’ll spend on a home. Lower interest rates may also translate to lower monthly payments, depending on the new home loan term. This additional room in your budget allows you to save or spend more to achieve your financial goals.
For example, a borrower who secures a principal mortgage for $250,000 with a 6% interest rate will pay $1,498.88 monthly.
A decade later, that borrower pays down their principal and has an outstanding balance of $200,708. If that borrower then refinances their mortgage and secures an interest rate of 4.5%, they’ll decrease their monthly payments to $1,016.96. Refinancing helped the buyer cut $481.92 off of their monthly payments.
Shorter Loan Duration
Even if your current loan interest rate competes with the market rate, refinancing your mortgage can still provide benefits. Borrowers can secure a new mortgage with a shorter mortgage term. A shorter term may increase their monthly payments but help them pay off the mortgage sooner, resolve their outstanding debt, and free up the budget.
For example, a borrower with a 30-year term on a $250,000 mortgage at a 6% interest rate pays $1,498.88 monthly. A decade later, they refinance their remaining $200,708 for a 15-year term, increasing their monthly payment to $1,535.40. While they’ll pay more each month for the remainder of their mortgage, they’ll pay off the home five years faster than they would without refinancing.
Acquiring a more aggressive payment plan may appeal to borroweres who improve their financial situation. Getting a raise or increasing monthly income can help homeowners afford higher monthly payments and a shorter loan term. Additionally, those who acquire a large sum of money, like an inheritance or bonus, may refinance and pay off a significant portion of the outstanding balance at once to bring down the remainder.
Learn more: Choosing Between a 30-Year and 15-Year Mortgage
Change Loan Type
Refinancing also offers borrowers the opportunity to change their mortgage type. Mortgages offers various interest rate structures, like variable-rate versus fixed-rate. A variable-rate mortgage determines the amount of interest a borrower pays based on the current interest rate. Those who borrow a variable-rate mortgage may therefore pay varying amounts each month. Fixed-rate mortgages maintain the same interest rate for the duration of the loan, so borrowers will not change the amount they pay each month.
Borrowers may choose to switch their loan type based on current interest rates. For example, those who borrowed a variable-rate mortgage when interest rates were near 3% may not be able to afford their higher monthly payments now that interest rates vary around 6%. Therefore, they may refinance for a fixed-rate mortgage.
Conversely, when rates decrease, borrowerse may refinance and switch from a higher, fixed rate to a variable rate. Variable-rate mortgages appeal to various homeowners, such as those who anticipate selling their home in the near future before rates rise again.
Avoid a Large Payoff
Some mortgages use a balloon payment close to the end of their term, where borrowers settle the mortgage by paying a large quantity at once. However, this large payment may become unachievable for borrowers, and they instead may opt to refinance and switch to a mortgage that does not have a balloon payment. In this case, a homeowner may need to opt for a longer mortgage term or increase their monthly payment amount to settle the mortgage.
Debt Consolidation
You can also use refinancing to consolidate outstanding debt. Collateralized mortgage debt typically pays down at favorable rates and terms compared to higher-rate, unsecured credit card bills. Debt consolidation may improve your credit score, which may help you qualify for better loans in the future, with lower interest rates and lower payments.
Access Equity in the Home
If you need cash to fund a large home improvement, college expenses, or even a second home purchase, refinancing can help you tap into the equity you’ve built over the years. As you pay down your mortgage, and your home increases in value, you’ll gain equity. This equity equals your ownership value of the home. If you purchase your home for $100,000 and borrow $80,000, at some point the property value may rise to $200,000. You can then increase the amount of your loan, according to the lender’s guidelines. You can then choose to direct the funds from the refinanced loan toward other expenses or investments.
How Do You Refinance a Mortgage?
Before refinancing, you should clearly understand your household budget and long-term objectives. Refinancing offers important financial benefits when you understand how a new mortgage affects your monthly payments and future road to mortgage satisfaction.
To start, homeowners can use a mortgage calculator to compare their existing loan to a loan with new terms and payment structures. This information can help bororwerse determine if they will benefit from refinancing.
Calculating the true cost of refinancing means factoring in all fees and closing costs. Although nothing will hold you back from refinancing your mortgage repeatedly, whenever rates move in your favor, you’ll need to recalculate the total interest paid and include the lender’s fees to help you determine how much of a financial benefit you’ll receive from a new loan. Keep in mind, it may take you longer to recover the costs through a refinance rather than staying on your current loan program.
Conclusion
Before you refinance, take the time to consider your ultimate goal. Do you want to lower your monthly payments or reduce the total amount of total interest you pay over the life of the loan? With a longer duration, you might lower the amount you pay each month but find yourself paying more interest as the life of the loan increases.
If you’re looking to restructure your debt, or pay off your home faster, talk to a financial planner or mortgage lender. Depending on current interest rates, you may have several refinancing options available.
