What's involved in Refinancing?



Refinancing is very similar to the process of getting a first mortgage, and the same rules and eligibility criteria apply. You will need a favorable credit rating and income-to-debt ratio, just as with the original mortgage. The cost of refinancing is an important point to consider when deciding whether or not it's a good financial decision.

Refinancing requires paying closing costs, points, and origination fees, appraisal fees for your property, and possibly a prepayment penalty depending on the terms and conditions of your mortgage. In general you can expect refinancing to cost between three and six percent of the amount of principal you have left to pay on your existing mortgage.

Reasons to Refinance

There are three situations in which refinancing will almost always pay off. First, if you have an adjustable rate mortgage and mortgage rates start rising, refinancing is usually the safest course of action. You can refinance to a fixed rate mortgage before interest rates get out of hand, and avoid the high monthly payments that go along with the higher rate. Refinancing out of an adjustable rate mortgage is also a good idea if you decide you prefer a lower-risk loan.

The second reason to refinance is to obtain a lower interest rate and save money on your monthly repayments. This can be a good idea regardless of what kind of mortgage you currently have, but there's more to consider than interest rates. In some situations, refinancing won't be the best option, even if interest rates are in your favor.

Finally, refinancing to decrease the terms of your mortgage is a good option if your financial situation changes to allow you to afford higher monthly payments. Refinancing in this situation can save you thousands of dollars in interest, even if you end up with a slightly higher interest rate than you currently have.

Many people choose to refinance for another reason. They may not be concerned with saving money on the mortgage, but instead want a "cash-out" mortgage, where some of the equity in their home is exchanged for cash. This is usually done to pay off other debts with higher interest rates or to finance a large purchase. Refinancing for this reason often seems like a great idea, but it's important to explore your options thoroughly before making the decision.

When to Refinance-and When to Hold Off

In general, refinancing is a good idea in any situation where doing so will save money. Interest rates are not the only issues to consider. Other factors such as the amount of equity you have in your home, how long you plan to live in the home, and how many years are left on your mortgage, also come into play when determining whether refinancing will pay off in the long run.

Refinancing will usually pay off if one of the following situations is true:

• You're refinancing out of a high-risk mortgage (such as an adjustable rate mortgage) to take advantage of favorable fixed interest rates or because you prefer a lower-risk mortgage
  
  
• You're refinancing from a fixed rate mortgage to a new fixed rate mortgage with shorter terms or a lower interest rate

In addition, for refinancing to pay off, you should also be planning to remain in the home until you've recovered the costs of refinancing with the savings you make on the new mortgage payments.

In some situations however, refinancing won't necessarily pay off even in cases where one of the above situations applies. For example, if your credit rating has decreased since you obtained the first mortgage, you may not qualify for an interest rate that's low enough to make refinancing financially worthwhile.

The amount of equity you have in your home also plays an important role in determining how feasible refinancing will be. If you're planning on a cash-out refinance, for example, you'll likely need private mortgage insurance if the amount of equity you retain in your home drops below 20%.

Finally, remember that cash-out refinancing should be approached with caution, particularly if you plan to use the cash to finance a large purchase or pay credit card debt. When you use the money in this way, you're turning unsecured debt into debt that is secured against your house. Using equity to pay off credit card debt, for example, can lead to problems if you end up creating more debt after refinancing.