Should You Refinance Your Mortgage?

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Editor's Note: This story originally appeared on Point2.

If you’re feeling the pinch of the current economic climate, you may have considered refinancing your mortgage.

However, this isn’t a choice you should make lightly. Understanding the ins and outs of mortgage refinancing is essential before deciding whether it’s the right move.

With that in mind, let’s look at how refinancing a mortgage works, what the risks are, and whether it’s a good choice for you.

How Does Refinancing a Mortgage Work?

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Refinancing your mortgage basically means taking out a new mortgage to pay off and effectively replace your original loan. While the process of refinancing is similar to obtaining your original mortgage, there are several benefits to doing it the second time around.

One of the biggest advantages of refinancing is that it allows you to switch lenders, leaving you free to shop around for the lowest interest rates and deals for your circumstances. This can result in more affordable repayments each month.

On top of that, you can also tap into your existing home equity, giving you access to a lump sum of cash.

How soon can you refinance a mortgage? In most cases, you can do it as soon as you want, although if you plan to stick with the same lender, you’ll generally have to wait at least six months.

The 3 Main Different Refinancing Options

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If you choose to refinance your mortgage, you’ll typically have three options depending on why you want to change your loan. In a broad sense, the three main reasons to refinance your mortgage are:

  1. To obtain a lower interest rate
  2. To access the equity you’ve built up in your home
  3. To lower your mortgage balance or increase your mortgage term

In both Canada and the U.S., three main refinancing options reflect these motives.

Rate-and-Term Refinancing

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Also known as “no cash-out refinance,” this type of loan aims to change the interest rate, the term or both, without making any changes to the loan amount itself.

Applying for this type of refinancing can be a sensible strategy, especially when interest rates drop.

It will work in your favor if you’re planning to reduce your monthly payments or looking to switch from an adjustable to a fixed-rate mortgage or vice versa.

Cash-Out Refinance Loan

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In this case, you can tap into your home’s equity by taking out a new loan, which results in a larger loan amount equal to the amount you have cashed out.

The new loan will essentially pay off your previous mortgage loan, and the remaining amount will be issued to you in cash.

This tactic is helpful if you’re looking to make money by using your home as collateral. You can then use the cash to make home improvements, pay off education or medical expenses, or invest in things like a business or even a second home.

Cash-In Refinance Loan

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The opposite of the cash-out refinance, this type of refinancing loan occurs when the borrower brings in money to lower their mortgage balance.

This tactic is useful if your home is underwater — i.e., the amount you owe on your mortgage is higher than the current property value — and you need to regain positive equity.

It’s also worth considering if you want to avoid mortgage insurance and benefit from lower interest rates.

Should I Refinance My Mortgage?

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This can be a tricky question to answer. There are plenty of great reasons to refinance your mortgage, with various advantages to be gained.

However, it’s essential that you do research, as it can cost you much more in the long run if you get it wrong. As such, it’s important to ask yourself the following questions.

1. What Is Your Refinancing Goal?

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First and foremost, it’s important to be clear about why you want to refinance your mortgage. As we’ve seen, there are three main reasons to do so, but sometimes, refinancing might not be the best option.

For example, if you’re looking to cash out and get your hands on the equity you’ve already built, a HELOC (home equity line of credit) might be a more viable option depending on your circumstances.

Likewise, if you want to switch to a fixed-term mortgage, waiting until your current mortgage term ends might make more sense to avoid potential penalties.

Of course, the economic climate can play a significant role, and when interest rates are low, the penalties can be worth it for the long-term gains.

2. Can You Afford the Costs?

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When you’re clear about why you want to refinance, the next thing to consider is whether it’s financially feasible to do so.

So, how much does it cost to refinance a mortgage? That depends on your situation, and there’s no one-size-fits-all answer here, although on average, you can expect to pay between 2% and 6% of your loan balance in closing costs.

Here are just some of the various costs of refinancing a mortgage:

  • Legal costs
  • Home appraisal fee
  • Application costs
  • Penalty charges for breaking your existing mortgage terms

Often, these costs are due upfront, so refinancing typically requires you to have cash available, often running into thousands of dollars.

However, in some cases, some of the closing costs can be rolled into your new loan, so be sure to ask potential lenders if that’s an option. Just be advised that this will result in larger repayments.

3. Do You Qualify for Refinancing?

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Like a regular mortgage, lenders have strict criteria you’ll need to meet before they agree to give you a loan. While these requirements differ from lender to lender, you’ll typically be assessed on the following:

  • Debt-to-income ratio (DTI)
  • Loan-to-value ratio (LTV)
  • Credit score

You must be fairly confident of qualifying for refinancing before applying, as the lender will make a hard inquiry to your credit report. If rejected, this can reduce your credit score.

4. Do You Have Enough Home Equity?

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Most lenders will require you to have built up at least some equity in your home, especially if you’re planning on a cash-out refinancing loan.

Check your statements to see where you stand by subtracting the outstanding loan value from the current value of your home. Bear in mind that your home’s value has likely changed since you first applied for a mortgage.

If your current mortgage loan exceeds your home’s market value, your property is considered underwater, and you’ll have negative equity. This will almost certainly result in your application being rejected unless you plan to inject cash into your home.

5. Do You Plan To Relocate?

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Refinancing your mortgage should be seen as a long-term plan, as it can take time to recuperate the closing costs before benefiting from the gains.

If you’re planning to move in the not-too-distant future, refinancing might not be your best option.

When Not To Refinance Your Mortgage

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If you’ve answered the previous questions, you should have a pretty good idea of whether refinancing is the best solution for you. However, there are a few more things to consider before you go ahead with it.

In a nutshell, refinancing your mortgage will typically leave you with reduced home equity and take you back to square one in terms of your borrowing journey. While it’s not always the case, this can result in higher costs in the long term, particularly in an unfavorable economic climate.

So, while it may seem like the ideal solution to today’s problems, it could mean you pay more interest in the long run.

Similarly, if you plan to take out your home equity as a lump sum, it’s essential to think about how much cash you need right now.

For instance, if you don’t require a large amount of money all at once, a HELOC could be a better alternative since it doesn’t require starting your mortgage from scratch.

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