The Fundamentals of Refinancing

July 5, 20238 min read
The Fundamentals of Refinancing
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Key Takeaways 

  • The aim of a refi is usually to, ultimately, gain a more favorable interest rate or monthly payment, or other contract terms.
  • Borrowers frequently seek to refinance when there has been marked changes in the interest rate environment, allowing for prospective savings.
  • While refinance is often sought because one’s credit has improved or they need an influx of cash, the most common reason for seeking refinancing is because interest rates have dropped.

If a real estate investor or homeowner seeks to change their interest rate or mortgage terms, they might consider mortgage refinancing. In effect, refinancing supplants the original agreement with a new one. Beyond that, many people do not know the ins and outs of the refinancing process. Exactly what is refinancing? Here is that explanation and more.

What is Refinancing?

Refinancing, commonly referred to as “refi,” is the process of modifying and supplanting an existing credit agreement’s terms, particularly regarding a mortgage or loan.

The aim of a refi, which must first be approved by the lender, is usually to gain a more favorable interest rate or monthly payment, or other contract terms.

Borrowers frequently seek to refinance when there has been marked changes in the interest rate environment, allowing for prospective savings.

In addition to mortgage loans, refinancing also frequently involves student loans and vehicle loans. Further, it is common for businesses to aim to refi mortgage loans on commercial properties, usually due to a better credit situation or reduced market rates.

Specifically, a mortgage refi replaces the current mortgage with a new one with a new principal amount and interest rate. The new mortgage pays off the old one, leaving the borrower with just one mortgage, usually with a better interest rate than the old one.

Note that what refinancing is not, is taking out an additional or second mortgage, such as a home equity line of credit or home equity loan.

Types of Refinancing

There are multiple types of ways to refinance, including:

  • Traditional mortgage refinancing, which adjusts the interest rate, terms, or both.
  • Streamlined refinancing can advance the loan process and, if the mortgage is with a U.S. banking institution, can reduce the interest rate.
  • Cash-out refinancing works like a traditional mortgage but includes a cash-out option to get funds at closing.

Refinancing: Risk Tradeoffs

As is the case with most things that potentially reap positive results, there are tradeoffs to refinancing. 

On the plus side, one may be able to get a lower mortgage payment and rate. It also may be possible to switch from an adjustable interest rate to a fixed rate, achieving predictability and potential savings. 

Moreover, a refi may be able to deliver a sizable amount of cash for whatever is needed, such as home renovation or paying off debts. Also, gaining a shorter loan term will permit savings on overall interest paid.

As for tradeoffs, while lower interest rates may be in the offing, the duration of the loan may be extended, so that one’s total interest payment over the loan’s life could offset savings from the new rate.

Also, if one has a fixed-rate mortgage, they won’t gain the benefits of dropping interest rates unless they refinance again. Further, a refinance could lower the equity one has in their home.

In addition, note that with a shorter-term loan, the monthly payment will likely increase, and closing costs must be paid on the refinance. 

The Role of Credit Ratings in Refinancing

Whether one is eligible for refinancing, and at what rate, depends largely on their credit rating. Generally, homeowners with lower credit ratings can expect, if they qualify at all, higher interest rates. In fact, a minimum credit score of 620 is required by most mortgage lenders. 

Note that because the banking institution will run one’s credit when a refinance is sought, a refi will ding the applicant’s credit score. However, the score drop will be minimal and temporary. The better news is that the borrower’s overall credit will potentially improve once the refinance is completed, because one’s debt load is smaller, monthly payments will be lower.

Refinancing: Is it Popular?

When interest rates drop, borrowers are often spurred to refinance their existing loans to benefit from such a reduction and lower their monthly payment. On the other hand, when rates go up, the demand for refinancing may drop as borrowers may discover that a refi may be less beneficial.

Economic conditions including inflation rates, economic growth, and jobless levels also affect the refi market. When the economy is stable and growing, borrowers generally feel more confident about their financial state and are relatively more inclined to consider refinancing options. By contrast, when the economy is slumping or uncertain, there may be a drop in refi applicants as borrowers focus on financial stability and reel in borrowing.

Real estate market trends are also factors in refinancing. In fact, the state of the market has a substantial effect on the refi market, particularly in mortgage refinancing, according to Custom Market Insights. When property values go up, homeowners may wish to refinance to take advantage of home equity or gain more favorable terms. Conversely, if property values are on the decline, or the market is unstable, homeowners are generally more likely to eschew refinancing.

Further, regulatory changes and policies in the financial industry can greatly impact the refi market. Government initiatives such as refinancing incentives or new mortgage relief programs can spur refinance activity. However, regulatory changes that tighten lending standards or heighten compliance mandates could affect the affordability and availability of refi options.  

How Does Refinancing Work?

It is common for those who seek refinancing to do so to reduce one’s interest rate to lower payments over the loan’s life, or to pivot from an adjustable-rate mortgage to a fixed-rate mortgage, or the other way around.

Sometimes people refinance because they have better credit or to consolidate existing debts into a single, low-price loan to pay them off. They also often do so due to changes to their long-term financial plans. 

The most common reason for seeking refinancing, however, is because interest rates have dropped. Factors such as market competition, the economic cycle, and national monetary policy can cause rates to go down or increase. Such rates can affect credit products ranging from credit cards to non revolving loans. When rates are going up, borrowers with variable interest rates wind up paying more in interest. The opposite is true when rates are falling.

Borrowers who seek to refinance must fill out a new loan application with a new lender or their existing one. The lender will then evaluate the borrower’s financial state as well as their credit terms. 

Here is an illustration of how refinancing works. Say John and Judy have a home with a 30-year fixed-rate mortgage. A decade ago, the couple locked in an interest rate of 8%. Then, due to changing economic conditions, interest rates dropped.

The two then contact their bank and are able to refi their mortgage at a lower rate of 4%, permitting them to lock it in for the next two decades while reducing their monthly mortgage payment. In the future, if interest rates drop again, John and Judy may consider yet another refi to further reduce their payments.

Here is how the numbers would look in a hypothetical situation: say a homeowner has a $165,000 mortgage with an interest rate of 6.5%, and there is now an opportunity to refinance at 4.5%. This is how 2% affects the mortgage payment, before taxes and insurance:

  • At 6.5%, the monthly mortgage payment is $1,042.91.
  • At 4.5%, the monthly mortgage payment is $836.03.

In this scenario, monthly savings are $206.88.

In general, refinancing a mortgage calls for the investor or homeowner to take these steps:

  • Shop around. Compare mortgage rates to find the best fit and to determine whether refinancing is worth it.
  • Prequalify. Apply with a lender to prequalify for new mortgage loan terms. The applicant will find out the amount for which they can qualify when refinancing.
  • Apply for a refi. After gaining an idea of the amount for which they can qualify for a mortgage, the mortgage refinancing loan process can commence.

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