Refinancing a mortgage involves paying off the existing mortgage, and replacing it with a new loan. In some cases, it is even possible to combine a first mortgage and a second mortgage into a new loan. There are several reasons homeowners refinance, including taking advantage of falling interest rates, switching into a different type of mortgage and getting cash out from equity in the home.
For borrowers with excellent credit, refinancing can be an excellent way to convert a variable interest rate into a fixed rate loan, or to obtain a lower rate. However borrowers with poor credit and too much debt, may be taking on more risk by refinancing.
Reasons to Refinance
1. Reduce the interest rate
Regardless of the amount of equity in the home, the main advantage of refinancing is reducing the loan's interest rate. This benefit is typically available to borrowers who have excellent credit and qualify for lower rates. Obtaining a lower interest rate can have a significant effect on monthly mortgage payments, potentially saving hundreds or thousands each year.
2. Cash out refinance
Many people also choose to refinance to take cash out of the home's equity for a large purchase or reducing credit card debt. Cash out refinances usually have slightly higher interest rates than regular refinancing, because the lender is risking more money. This type of refinance is not right for every borrower. While the interest rate on this new debt will be much lower than credit card debt, the interest charges may be in the thousands, because they are spread over 30 years. Doing this also converts unsecured credit card debt into debt that is secured by the home.
3. Refinance into a different type of mortgage
Another reason homeowners refinance is to get out of a mortgage type that may become unaffordable. This includes getting out of an adjustable rate mortgage (ARM), interest-only mortgage, piggyback loan or any other type of mortgage provision. Some homeowners who wish to avoid a balloon payment (or homeowners who have an ARM that is about to reset) can switch into a new fixed rate mortgage.