What is Loan Refinancing?

Loan refinancing involves taking out a new loan, usually with more favorable terms, in order to pay off an old one. Terms and conditions of refinancing vary widely. Refinancing is more commonly associated with home mortgages, car loans, or student loans. In the case that old loans are tied to collateral (assets that guarantee loans), they can be transferred to new loans. If the replacement of debt occurs under financial distress, it is called debt restructuring instead, which is a process to reduce and renegotiate delinquent debts to improve or restore liquidity.

Reasons to Refinance

Save Money—If a borrower negotiated a loan during a period of high interest rates, and interest rates have since decreased, it may be possible to refinance to a new loan with a lower interest rate. This saves money on interest costs for the borrower. It is also possible to refinance when a borrower's credit score improves, which may qualify them for more favorable rates. This can in turn improve credit score even further if borrowers use the money saved to pay off other outstanding debts.

Lower Payment Amount—Borrowers struggling to meet the minimum monthly payments on a loan can refinance to a new loan with lower required monthly payments, which can help ease the financial burden. However, most probably, this will increase the loan term and increase the total interest to be paid.

Shorten the Loan—Borrowers can potentially pay off their existing loans faster by refinancing to shorter loan terms. One of the most common examples is refinancing a 30-year mortgage to a 15-year mortgage, which typically comes with a lower interest rate, though this will most likely result in a higher monthly payment.

Consolidate Debt—Managing one loan with a single payment date instead of multiple loans with multiple payment dates is much simpler. This can be achieved by refinancing multiple loans into a single loan (especially one that has a lower interest rate than all previous loans).

Switch from a Variable Rate to Fixed, or Vice Versa—It is possible to use loan refinances to make the switch from variable interest rates to fixed interest rates in order to lock in low rates for the remaining life of the loan, which offers protection from rising rate environments.

Refinance Mortgages

Refinancing a mortgage may come with different benefits such as getting a lower rate, switching from an adjustable rate mortgage (ARM) to a fixed mortgage, consolidating combo mortgages or other debt, removing someone from a loan (example being ex-spouse), and more, depending on the type of refinancing. Several types are explained in detail below.

Cash-Out Refinance—It is refinancing with a new loan amount higher than the remaining owed amount on existing mortgages. The difference goes to the borrower in cash. Generally, borrowers need at least 20% equity in their property to be eligible for cash-out refinances. As with most loans, there will be fees associated with cash-out refinances, typically hundreds or thousands of dollars, which should be factored into the decision-making process. Essentially, cash-out refinancing involves turning the equity built in a home into additional money. Some borrowers use the money for home improvements. Others may use it for situations such as medical emergencies or car repairs. It can also be used it to pay off credit cards or other high interest debts.

On the opposite side, borrowers can also contribute more money towards the settlement of a mortgage in order to reduce any remaining principal; this is referred to as a cash-in refinance.

FHA Refinance—While mortgages from the Federal Housing Administration (FHA) have less stringent down payment requirements, unlike conventional loans, mortgage insurance premium (MIP) (not to be confused with the additional upfront MIP that's 1.75% of FHA loan value) payments are still required after 20% home equity is reached. This can be circumvented by refinancing from an FHA loan to a conventional loan after 20% equity value is reached, since conventional loans do not require MIP payments after this point. In some cases, this will result in a less costly loan and a smaller monthly payment. There is also an FHA Streamline Refinance in order to refinance an existing FHA loan into a new FHA loan, which usually results in a reduced rate. Note that a credit check is required, and the mortgage must be in good standing in order to use this option. For more information about or to do calculations involving FHA loans, please visit the FHA Loan Calculator.

Rate and Term Refinance—This method refinances the remaining balance for a lower interest rate and/or a more manageable loan term. This differs from a cash-out refinance. Rate and term refinances are common when interest rates drop.

ARM Refinance—Refinancing an ARM (when it is about to go through an adjustment) to a conventional fixed rate mortgage during a period of low interest rates can result in a new, more favorable loan. While ARMs usually provide a lower interest rate initially, they may rise during the latter stages of the loan due to changes in the corresponding financial index.

Mortgage Refinance Costs

When refinancing mortgages, there are a number of common fees that may apply. There is an input in the calculator to consider these in the subsequent calculations.

Mortgage Application Fee—Lenders may charge about 1% of the loan amount to process mortgage applications, approved or not. Home Appraisal—Lenders usually require the appraisal of the house value in order to evaluate changes in value, and whether borrowers have enough equity for successful application. This typically costs a few hundred dollars. Loan Origination Fee or Mortgage Points—Normally 0-2% of the loan amount, used as compensation for putting loans in place. Documents Preparation Fee—On average, a few hundred dollars to pay for the preparation of important documents such as the Truth-in-Lending disclosure. Title Search—In the amount of a few hundred dollars, this fee is paid to a title company to research court records, prior deeds, and property databases to guarantee the title is free and clear of liens. Recording Fee—This is a charge for handling paperwork through counties or cities, and is usually a few hundred dollars or less. Flood Certification—In certain geographical areas, flood certification is necessary. Inspection Fee—This is a fee to evaluate the conditions or working order of the property (plumbing, electrical, pests, roofing, HVAC, and anything else that may apply). Usually a few hundred dollars. Survey Fee—A survey of the property ensures proper boundary lines to prevent encroachment by adjacent properties. An existing survey may be used. If a new survey needs to be obtained, expect to pay a few hundred dollars.