In the context of real estate, refinancing refers to the act of changing the financing terms of your existing home loan or mortgage. When you decide to refinance your mortgage, your aim should be to procure a more favourable interest rate or adjust your payment schedule to give you a more favourable deal, which would contribute to your additional savings. Many borrowers choose to refinance when the prevailing market interest rate is significantly lower, as it allows them to capitalise on the lower interest rates to lower the total amount of interest paid on their mortgage.
Types of Refinancing
There are a myriad of refinancing options available depending on your needs. Some of these options include:
Rate-and-term refinancing is the most common type of refinancing where the interest rate and/or the loan term of the mortgage is adjusted. This is usually triggered by a drop in market interest rates. If you have a fixed-rate mortgage and the current market interest rates are lower than the current interest rate on your existing loan, consider refinancing your mortgage to reduce your monthly payments.
During a low interest regime, you can also consider converting from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, which improves predictability on your monthly payments.
Cash-out refinancing usually occurs when the overall value of the collateralised property increases, and borrowers wish to optimise the equity of the asset. Cash-out refinancing is performed by withdrawing part of the equity in the asset by increasing the loan amount. Instead of selling your property to materialise the increased earnings, you do so by taking out a new or larger loan quantum.
Cash-out refinancing can also be considered if you have paid off a significant amount of your mortgage and require substantial funds on a short notice. Adopting this approach would result in an increase of the loan-to-value (LTV) ratio on your property. Cash-out refinancing increases the liability in terms of the principal owed to the lender on your mortgage, which will consequently impact your monthly payments.
Cash-in refinancing involves voluntarily repaying a portion of your loan to reduce the amount of principal owed to the lender, thereby increasing your equity in the property. Cash-in refinancing results in lower monthly payments over the period of the loan, as a portion of the loan has already been paid upfront. Furthermore, cash-in refinancing results in a lower LTV ratio. A lower LTV ratio means there is less risk to the lender, and the lender may be able to provide a lower interest rate, further reducing your monthly payments.
Advantages and Disadvantages of Refinancing
Refinancing your mortgage allows you to:
- Negotiate a lower interest rate and reduce your monthly payments
- Convert your adjustable-rate mortgage to a fixed-rate mortgage, allowing for more predictable and consistent repayments
- Acquire a large sum of money quickly at mortgage rates
- Reduce the tenure of the loan to lower the total interest payable
However, refinancing also comes with various costs that you should be aware of:
- If you refinance your mortgage and the loan term is reset to its original length, the total interest paid due to the extension of the loan term may be more than the savings made from getting a lower interest rate.
- If the interest rate drops further after you have refinanced a fixed-rate mortgage, you will not be able to benefit from the lower interest rates unless you refinance again.
- Refinancing may reduce the equity that you hold in your property.
- If you shorten your loan term, your monthly payments may increase even if you pay less interest in the long run.
- There are various administrative costs, such as legal fees, associated with refinancing your mortgage.
Examples of Refinancing a Mortgage
For example, you have secured a 30-year fixed-rate mortgage when you bought your first home in 2012 with an interest rate of 4%. After servicing the mortgage for 10 years, you realise that the current interest rates are much lower at 1.5% and you wish to lock in the lower interest rate.
One option would be to refinance the balance on the original mortgage at a 1.5% interest rate for a new 30-year term, provided no other restrictions exist. The new loan will then have a lower monthly payment, but you would need 10 more years to pay off the mortgage as compared to if you did not refinance the mortgage. However, the additional 10 years of monthly payments could chalk up interest that may offset your savings with the lower interest rate.
You could also choose to pay the new interest rate and negotiate a shorter mortgage term of 15 years. Your monthly payments may be higher than what you initially had, but you will end up paying less interest in the long run.
Therefore, it is important for you to calculate the savings made from refinancing to evaluate whether it is worth it.
The Bottom Line
Refinancing can be a great tool for you to secure better interest rates and increase your overall savings, or to cash out on the equity in your home if you find higher yielding alternatives. However, be sure to understand your own financial situation and assess the corresponding risks involved so that you can benefit and maximise your savings from refinancing your mortgage.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.