In real estate, refinancing is the process of replacing a current mortgage with a new mortgage that usually extends more favorable terms to the borrower. The terms and details of the new contract can be customized by the borrower.
Understanding Refinanced Mortgages
A mortgage is a loan that is taken out to finance the purchase of some sort of real estate asset, such as a house, office, shopping center, industrial plant, etc. Mortgages are a very commonly used debt instrument that is secured by the underlying property that is being bought. Since the mortgage is backed by the property itself, it is usually considered one of the safest loans from the lenders’ perspective.
The mortgage comes with terms that are established on the onset of the loan. However, over time, the borrower may wish to refinance the mortgage to benefit from better terms. The borrower may be able to customize the terms of the mortgage by making a few changes, such as:
There are many different types of mortgages since there is not a one-size-fits-all when thinking about the different types of purchasers and properties available. Mortgages are customizable and allow borrowers to edit the terms of the mortgage based on their personal situations. These situations can dynamically change over time, and that is why mortgage refinancing is valuable.
Some common types of mortgages are a 15-year fixed-rate or 30-year fixed-rate mortgage; however, the loan’s terms can vary depending on the borrowers’ needs. Generally, a longer-term mortgage would mean lower monthly payments, but a higher balance of interest paid over the life of the loan. On the other hand, a shorter-term mortgage would mean higher monthly payments, but a lower amount of interest paid over the life of the loan.
There are also fixed-rate mortgages and variable-rate mortgages. With a fixed-rate mortgage, the borrower agrees to pay a fixed interest rate over the life of the loan. This reduces the risk for the borrower, as their monthly payments are predictable. However, fixed-rate mortgages limit the benefits of being able to take advantage of lower market interest rates in the future.
With a variable-rate mortgage, the borrower agrees to pay a variable interest rate over the life of the loan that fluctuates with the market interest rates. The starting interest rate is generally lower than the market rate to make it appear more favorable. However, there is a higher risk from the borrowers’ perspective of the market interest rates potentially increasing in the future.
Types of Mortgage Refinancing
The three main types of mortgage refinancing include:
1. Rate-and-term refinancing
The most common type of mortgage refinancing is known as rate-and-term refinancing. This type of refinancing allows the borrower to refinance the mortgage with an adjusted rate or adjusted term for the mortgage loan. The borrower can take advantage of the economic environment or adjust the mortgage to fit their personal situation better.
For example, if market interest rates are decreasing, the borrower may want to initiate a rate refinancing to adjust the interest rate that they pay downwards. Additionally, if a borrower starts to earn more and can afford a higher monthly payment, they can initiate a term refinancing that allows them to shorten the term of the mortgage loan. A shortened term means higher monthly interest payments, but a lower amount of total interest paid over the life of the loan.
2. Cash-out refinancing
Cash-out refinancing may also feature customization of the rates or terms of the mortgage loan. However, the main distinction for cash-out refinancing is that the new mortgage loan is greater than the initial mortgage loan. The value of the new mortgage in excess of the old mortgage is subsequently paid out as tax-free cash to the borrower. It is tax-free since the amount paid out does not contribute to taxable income for the borrower.
For example, if a current mortgage is $200,000, but the borrower wishes to cash out on the equity portion of the property, they may initiate a cash-out refinancing that increases the mortgage to $250,000, and they receive $50,000 in tax-free cash.
3. Cash-in refinancing
Cash-in refinancing is the opposite of cash-out refinancing. With cash-in refinancing, the borrower actually uses cash for a new mortgage with a lower loan balance than the initial loan. Cash-in mortgages may result in a lower mortgage rate, a shorter term, or both.
The main benefit is that since the loan value is being reduced, the borrower can receive a more favorable interest rate on the new mortgage taken out.