You’ve probably heard the term “refinancing” floating around. It’s often described as a way that borrowers can pay lower fees and keep their loan or mortgage while easing their own burden. But what is it? When should a borrower refinance? Are there different types of refinancing? We’ll get into the nuts and bolts of what refinancing is, different ways that people can get refinancing, and when and if you should do it.
What is refinancing?
Refinancing is when you work with a lender to find different conditions for your current loan or mortgage. There are a lot of reasons borrowers will seek refinancing. These include getting better rates, working with a different lender, getting money out of your home’s equity, or changing from a fixed rate to a variable or adjusted rate mortgage.
There are a few reasons why lenders might want to switch rate types or terms. If interest rates are expected to go down, a borrower with a fixed rate mortgage might want to switch to an adjusted rate mortgage. This means they can expect to pay less moving forward as interest rates go down. If interest rates are expected to go up, a borrower might want just the opposite. They may want to be fixed in at a good rate moving forward.
Types Of Refinancing
There are different types of refinancing. Depending on your personal situation—what type of loan you have, what you’re looking for, your original terms, your borrowing history, and your current credit history—different types of refinancing might be right for you.
Rate and term refinancing is a very common refinance strategy. When people talk about refinancing, this is often what they’re talking about. With a rate and term refinance you’ll “switch” mortgages for one that might have different rates and terms—hence the name. Rate and term refinancing has some requirements, so depending on where you stand, you may or may not be eligible.
One of the requirements you’ll probably see is your LTV, or loan-to-value ratio. Your LTV ratio is the amount you owe on a loan in relation to how much the total value of the home is. This will show how much equity you have in your home. It tells lenders how much of your home you’ve already paid off—and the more you’ve paid off, the better. This signals to lenders that you’re less likely to default. It also lets them know you might be a better candidate for a better term or better rates.
Another requirement you’re likely to see is your credit score. This is a cumulation of your borrowing history and credit history. Like your LTV, it lets lenders know if you’re a good candidate for a mortgage refinance.
A third requirement for a rate and term refinance is your DTI, or debt-to-income ratio. This is the amount you’re bringing home every month and how much you owe each month. A DTI that’s low will let lenders know that paying off your debt is no problem.
Cash out refinance involves using your home’s equity to your advantage. With a cash out refinance, you can access money through the value in your home which in turn can help you deal with your debt better or make a large purchase. There are two primary ways your equity in a home might’ve increased:
- You have put more money into it.
- Your home’s value has increased.
Either way, with a cash out refinance, you’re taking advantage of this to secure a new loan using your increased equity. With a cash-out refinance, you’ll borrow more than the amount you still owe on your home. When securing a cash out refinance, you’ll usually be required to keep some equity in your home— so the more you’ve already paid off, the more you’ll be able to get.
In stark contrast to a cash out refinance, a cash in refinance might be right for you if you have a lower equity in your home, and you want to increase it in order to get better terms or rates. With a cash in refinance, you’ll pay a large amount into your home all at once, in order to increase your equity in the home, which in turn can make you eligible for better financing.
For instance, say you owe 90% on your home still. It is time to recall the LTV ratio! By paying in and increasing your equity in the home, you can get your LTV ratio down, and secure better refinancing this way.
When Should I Refinance?
Now that we’ve talked a bit about different types of refinancing and what refinancing is, its time to consider when refinancing might be a good choice for you. There are a few reasons that can affect your decision, like:
- Your financial situation
- The amount of equity you hold in your home
- What interest rates look like at the moment
- What interest rates looked like when you secured your original loan
- Your short and long term goals
- What your credit looks like
If interest rates are currently trending lower than when you originally secured your mortgage, or when you last refinanced, it may be a good time to look at a rate and term refinance. If you have the credit score and enough equity in your home, you might be able to secure lower interest rates, a better term, or both. However, interest rates are trending higher than when you secured your loan, so it may be best to hold off and wait.
Your Home Equity And Upcoming Expenses
If you’ve already built up a lot of equity that you hold in your home, and you have upcoming big expenses, it may be a good time to take a look at cash out refinancing. With cash out refinancing, you’ll be able to make use of the equity you hold in your home to access money you can use to help pay off other expenses.
However, if you have low equity in your home and you’re looking at securing better rates or terms on your mortgage, it might be worthwhile to look at cash in refinancing. With cash in refinancing, you might be able to secure a more competitive mortgage with better rates or a better term.
We’ve talked a bit about refinancing, what it is, and when it might be a good idea. Depending on your situation, sometimes refinancing is the best move you can make on a mortgage. With refinancing, you can sometimes secure better terms and rates on your mortgage, use your home’s equity to leverage cash for big expenses, and even pay farther into a mortgage to secure better rates going into the future.
Other times, the best move may be to sit back and wait—get your credit score up, wait for interest rates in the market to go down, or keep building equity in your home. Each situation is unique, so it’s always a good idea to talk to a lending expert or financial advisor if you’re not sure what to do next. But in some situations, refinancing is a great step in building your financial future.
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