How Does Mortgage Refinancing Work?

Mortgage refinancing simply refers to taking your existing mortgage and replacing it with a new mortgage. Your new mortgage is used to pay off your existing mortgage, and may also come with upsides such as a lower interest rate. The process is similar to that of refinancing a regular loan.

The main reason to refinance your mortgage is usually to get a lower interest rate. For example, if you take out a mortgage with a 7% interest rate, and a few years later, interest rates drop to 4%, then it may be sensible to refinance your mortgage. Over time, you will save money on interest payments, paying less money in interest to your lender overall.

However, there may be some drawbacks to refinancing. Many lenders will charge you “closing costs” for refinancing your mortgage. These are expensive fees that are designed to deter you from refinancing. Most lenders will administer closing costs in one form or another, so be sure to take these into account. Steep closing costs may mean that you pay more money (or a similar amount of money) overall despite your new lower interest rate, deeming your new lower interest rate pointless.

It is also important to bear in mind that repeatedly refinancing your home is not usually a good practice, as you will often pay more money in interest over the long run anyway. Stretching out loans can leave you paying more money overall over longer periods of time, as you are constantly delaying the date by which you will fully own your property (and will no longer have to pay your mortgage or the attached interest). Always calculate refinancing decisions carefully, working out what will be the best option in the long run.

You can also “cash out” refinance your mortgage, which has become increasingly prevalent in recent years. Cash out refinancing refers to getting a new mortgage whilst extracting any existing equity that you have in your home. This equity (i.e. cash) may be used by homeowners to pay for costly purchases such as college tuition fees or personal debt. Although cash out refinancing is a short-term solution for receiving large amounts of cash (derived from your home’s equity), you will usually lose out in the long run. Cash out refinancing mortgages often come with higher interest rates attached, meaning that you will pay more money in interest in the overall. You also have to consider that you are essentially starting your mortgage from scratch again, and will have to pay off all the equity that you lost – with interest.

Refinancing your mortgage can be a good way to save money, but it requires you to crunch a lot of numbers. Be sure to take into account any closing costs and fees that you may have to pay, and ensure that what you are paying in interest (over the lifetime of the mortgage loan) will be lower than what you are paying currently.