Mortgage refinancing is the process of creating a new loan on a property that has an existing mortgage. When a property owner refinances, the existing loan is paid off by the new lender and a new loan is created between the borrower and the new lender.
The two most common reasons that people choose mortgage refinancing are: 1)reducing the interest rate and/or term of the loan and/or 2) taking cash out by accessing the equity in the property. In a "Rate and/or Term" refinance, a borrower creates a new loan with an interest rate and/or term that is less than the original loan without accessing the home's equity. More than likely, the new loan amount will not be considerably more than the original loan amount. A borrower may choose to do this because a lower interest rate may reduce their monthly payment, while a shorter lease term may reduce the amount of money paid in interest to the lender over the life of the loan.
Mortgage refinancing involving accessing the equity in a property is commonly known as a "Cash-Out Refinance." Equity is the positive difference between what is owed on a property and what the property is currently worth. For example, if a home owner owes the bank $100,000 US Dollars (USD) on a property that is currently worth $150,000 USD, the owner has $50,000 USD of equity in the home. If this owner chooses to do so, he can refinance the home, create a new loan, and as a part of the loan, cash out some or all of the $50,000 USD of equity that the home currently has.
On a rate and term refinance, a borrower should calculate what the actual monthly savings will be with the new loan as compared to the old loan. Next, the borrower should look at the total cost of obtaining the loan. Common charges include lender origination fees, pre-paid interest or points, credit check, appraisal, tax, title, and escrow fees. Then a borrower should determine how long she plans to live in the current home. Once a borrower has all of this information, she can calculate how long she must own the property before the savings per month justify the up-front loan costs.
For instance, if mortgage refinancing enabled a borrower to save $100 USD per month, and if the up-front costs of the loan equaled $5,000 USD, the homeowner would need to live in the home for at least 50 months, or a little over four years, to recoup the cost of originating the loan. If the owner planned on being in the home for only two more years, it would probably not make financial sense to refinance, as the loan would cost more than the borrower would save. If the owner planned on living in the home for 20 years, refinancing may be a smart financial decision.
With cash-out mortgage refinancing, a borrower should consider that accessing the equity and taking cash out will result in a new loan amount larger than the existing mortgage, often resulting in higher monthly payments. Great thought should be given to determine whether the intended uses of the money are worth the possible increases in the total loan amount and monthly payment. Generally speaking, many financial experts believe that a home's equity should be used primarily for home improvements that will increase the value of the property.