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What is the Purpose of Home Refinancing? (Should You Refinance?)

The most common reasons to refinance include obtaining a better interest rate or paying for a renovation, paying debts, or property purchase.

Different branch of refinancing.

Ideally, when you refinance a home, you save money. This can happen in one of a few ways, but if you can’t find a way to save on the refinanced mortgage, you should keep the existing loan you’ve got.

The most common reasons to refinance include obtaining a better interest rate or financing a renovation or new property purchase. You also might want to get rid of your required mortgage insurance or use the money from the refinancing to consolidate debts and pay them off.

Refinancing your mortgage for any reason requires research and careful application. Avoid accepting the first offer you receive, since lenders compete for homeowners who want to refinance. Read on to learn how to refinance your existing loan for a new mortgage and find out the details of why you’d want to do so.

What happens when you refinance your home? As this infographic depicts, refinancing your mortgage should provide you with better terms or conditions like lower mortgage payments, reduce your debt, lower your interest rate, help you buy a new property, or provide you with cash from your home’s equity.

What is Refinancing?

The term refinancing refers to the process of revising a mortgage agreement and replacing it with a new one. Typically, a homeowner chooses to do this to improve their interest rate or to obtain cash from the equity in their mortgage.

Equity refers to the value of the home that the homeowner owns. The day you purchase your home, you own zero equity in it. You may have made a down payment, but the bank owns the mortgage and the title or deed to the home. That means the bank owns the home. As soon as you make the first payment, you begin accruing equity in your home.

Let’s say that your home cost $200,000. You paid a 10 percent down payment of $20,000 and took out a mortgage for $180,000. Your payments cost $1,000 per month since you qualified for a 5.3 percent interest rate. Once you pay your first payment, you own 1/180 of your home. After two full years pass, you’ve paid $24,000 and own 7.5 percent of your home. Said another way, you have 7.5 percent equity in your home or $24,000 of equity in your home.

Refinancing either lets you obtain part of the equity as cash, called a cash-out mortgage, or obtain better terms that lower the interest rate. Use a mortgage calculator to easily determine costs.

Your credit score decides your interest rate. If your score falls between 781 to 850, you’ll qualify for the lowest rates, currently hovering around three percent. A 661 to 780 gets you an interest rate of about four to 5.5 percent currently.

The Truth About Refinancing Your Mortgage Loan

It takes doing quite a bit of math before you ever contact a bank or other financial lender to determine if you should refinance your loan. Every article you read tells you the glories of refinancing, but I’m going to tell you a secret. It costs money to refinance your mortgage.

Refinancing costs you the same money it did to close on the home in the first place, regardless of whether you choose traditional refinancing or cash-out refinancing. Just as with the first mortgage, you must pay closing costs, including:

  • Application fees,
  • Loan origination fees,
  • Title insurance,
  • Closing fees.

That means that in order to determine if it benefits you or not, you need to do the math to figure out how much refinancing would cost you. If the interest rate for which you qualify, would not benefit you, there’s no reason to refinance. Refinancing should save you money in the long run.

What Happens When You Refinance Your Home?

Home figure with money and a piggy bank for financing.
Image of a home figure with money and a piggy bank for financing.

When you refinance your home, you obtain a new mortgage for the amount you still owe on your home. With traditional refinancing, you still keep the equity you already own. Think of the equity as the gold coins to the right in the photo above. The piggybank stands for the money you’re continuing to pay into your mortgage. Think of your home as the home in the photo. By refinancing, you can either make it nicer or pay it off sooner.

Mortgage Refinancing Meaning with Example

Let’s explain refinancing’s meaning with an example. After two years of making mortgage payments, you have that 7.5 percent equity. Mortgage loan rates fell a bit since you took out your loan. You also raised your credit score by 50 points! You now qualify for the best interest rates the bank offers. You had a 735 when you purchased your home, but after two years of perfect payments you brought it up to 785!

You now qualify for three percent interest, while your current mortgage charges 5.3 percent. How much money would two percent save you? You’ve got many years left on that mortgage and $156,000 left to pay. Your new monthly payment costs $758.89. If you don’t lower what you pay in and keep paying $1,000 per month though, you would save $29,121 over the life of your loan.

That’s money you can put into retirement savings, investments, or high-yield savings accounts to grow it even more. You can use the mortgage refinancing/payoff calculator on AARP to try different scenarios.

Cash-Out Refinancing: How to Cash-out Refinance Your Home for Renovations, Purchases, or Debt Payments

Living room area requires renovation
Half of the living room area requires renovation.

Here’s how to refinance your home for renovations. With cash-out refinancing, you can pay for a renovation to completely update your home, thus increasing its value and equity in it. When you choose a cash-out refinance mortgage, you leverage a portion of your equity, which the bank gives you as cash. The amount you take gets added back to your mortgage loan.

That means if you owe $156,000 and you use $10,000 of equity and refinance, your new mortgage loan totals $166,000. You must repay the equity you used. Essentially, the bank re-purchased that $10K from you. The $10,000 that you reinvest in your home by updating it increases its value. You own that equity. That part of the value of your home remains yours. You need to have your home appraised after the renovation to quantify its new value.

Calculating funds for cash-out refinancing
Calculating funds for the purpose of a cash-out refinancing.

Cash-out refinancing also provides you with a lump sum of money that you can use to pay down your debts. You typically nab a lower interest rate than the one from your first mortgage, and you can take a portion of your equity as cash to pay off credit cards or student loans.

A portion of land for sale ready for purchase
A portion of land for sale that has been partitioned and is ready for purchase.

Mortgage refinancing also allows you to fulfill your dream of purchasing an investment property. You can use the $10,000 as a down payment on a new property or purchase land as a real estate investment.

Houses in various architectural styles
Houses near the lake in various architectural styles.

A cash-out refinance mortgage loan can also provide you with funds to purchase the vacation home you’ve dreamed of owning. Cash-out refinancing lets you use the money you obtain in any way you want but with a better method than a home equity loan.

Should You Refinance Your Home?

This answer depends totally on your situation. Do the math. If refinancing your mortgage loan benefits your finances by saving you money every month on your interest rate, reducing your monthly payment, or you could get money back to make headway on renovating or debt payoff, it makes sense. Just make sure that the closing costs won’t take up most of the money. As long as you can keep those costs low and obtain a better interest rate, refinancing makes sense.