Refinancing Your Home Loan - A Beginner's Guide to Refi

By Brandon Cornett
© 2011 All rights reserved

Does refinancing your home loan make sense right now? How much will it cost to refinance your mortgage? What are the steps involved? These are just a few of the questions we will address in our refinancing checklist.

Let's start with a quick definition, just so we are all on the same page:

Refinancing is the act of replacing your current mortgage loan with a new one. The new loan will also have new terms and conditions associated with it. Most people refinance their homes in order to secure a lower interest rate, thereby reducing the size of their monthly payments. Some people use refinancing as a way to pull equity out of their homes (this is known as a cash-out refinance).

Let's talk about the different considerations you need to make when refinancing your home loan. Just keep in mind the process varies from one borrower to the next.

Is Now a Good Time to Refinance?

Are interest rates falling right now? Has your home's value risen since the time you bought it? If so, you're probably in a good position to refinance your mortgage loan. In most cases, you need to have one or more of the following things going for you:

• Mortgage rates are currently falling, or have fallen in recent months.
• The value of your home has appreciated significantly since you bought it.
• You are less than 10 years into a 30-year mortgage loan.

Why are these things important? Let's look at each one in turn.

Are mortgage rates falling?

If you refinance your home when interest rates are falling, you could benefit in two ways. You could end up with a lower mortgage payment each month, while keeping the term (length) of the loan similar to what it was before. Secondly, you could shorten the term while keeping your payments close to where they are now.

Depending on your situation, you might be able to achieve one or both of these goals when refinancing your home loan. Both of these things will reduce the total cost of the loan over time, by lowering the total amount of interest you have to pay.

Has your home appreciated in value?

If the market value of your home has risen steeply since you first purchased it, you could refinance to capitalize on your newfound equity. This is referred to as cash-out refinancing. Many homeowners use this strategy to pay for home renovations or college tuition, or to pay down other high-interest debt. Even if you're planning to do a "regular" refi (without pulling cash out), the lender will require you to have a certain amount of equity.

How much equity do you need? Generally speaking, lenders will require at least 5 percent equity for basic refinancing (to change the rate and term). If you want to do a cash-out refinance loan, you'll probably need at least 10 percent equity.

How far into the payback period are you?

Are you refinancing your home to save money over time? If so, you need to familiarize yourself with the break-even point. Simply stated, this is the point where the money you save (by lowering your payments) exceeds the money you spend (in closing costs on the new loan).

If you're more than halfway into a 30-year repayment term, you probably won't reach the break-even point. You won't enjoy those lower payments long enough to make up for the amount you pay in closing costs. Yes, you're going to pay closing costs again when refinancing your home loan -- just like you did when you first bought the house.

In the early years of your mortgage, most of your payment goes toward interest. This trend reverses over time. Toward the end of your repayment period, most of the payment gets applied to the principal. This is referred to as mortgage amortization. As a result of this trend, refinancing makes more sense in the early years. In the latter years (when most of your payment goes toward the principal), you're probably better off keeping the loan.

You don't necessarily need all three of things going for you -- though it would certainly help. It's all a matter of degree. For instance, if you're a little more than 10 years into your mortgage, but rates have dropped considerably, refinancing the home could still work to your advantage. If the money you save is greater than the money you spend to close the loan, then it makes sense to move forward.

Do You Need to Pull Cash Out?

When refinancing your home, you might have the chance to convert your equity into cash. This can be done through the cash-out refinance we talked about earlier. Whether or not you're able to do this will depend on the amount of equity you have.

The process here is fairly straightforward. You would get a loan that's larger than your current loan balance, receiving a cash payment for the difference. So you're replacing your current mortgage and getting an extra cash amount on top of that. It's all done through one loan. Of course, this increases the total amount of mortgage debt you owe.

The most common reasons for cash-out refinancing are:

• Home improvements. This can be a smart use of your equity, especially when it adds resale value to your house.
• College tuition. Many homeowners tap their equity to pay for college, either for themselves or their children.
• Debt consolidation. You can use a cash-out refinance to pay off some of your other debts, particularly those with higher interest rates. You're basically moving those debts into the lower interest rate that's assigned to your new mortgage. This would reduce the amount of interest paid for those debts.
• Second home. During the housing boom, many homeowners leveraged their current homes to buy second properties. They used cash-out refinancing to get funds for the down payment on the new purchase. Today, some lenders won't allow this kind of over-leveraging. So it might not be an option for you.

Once you've answered these preliminary questions, you're ready to move forward with the refinance process. You'll need to check your credit and figure out how much equity you have, among other things. You can learn more about these steps below.

Continued: The 5 Steps to Refinancing Success

Disclaimer: This article explains some of the key considerations when refinancing a home loan. It is meant to be a basic introduction, not a complete education. You need to weigh the pros and cons of mortgage refinance before you move forward. In other words, you have more homework to do! You can use our refi library to learn more about this topic.