What Is Refinancing?

By Markets Fool.com

When you take out a loan, what you're essentially doing is agreeing to repay the amount you owe at a certain interest rate over a specified period of time. But what if you could find a way to improve the terms of your loan? It's for this reason that refinancing has become a popular option for borrowers, particularly homeowners, in recent years. In the context of a home loan, refinancing is the process of replacing an existing mortgage with a new one, typically with more favorable terms. It's also possible to refinance other types of debt, like student loans.

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Benefits of refinancing

The primary benefit of refinancing is to save money on your loan. The goal of refinancing a mortgage is to lock in a lower interest rate, which translates into lower monthly payments.

Let's say you have a $100,000, 30-year fixed mortgage at 4.5% interest with a monthly payment of approximately $700. If you're able to refinance to a 30-year fixed mortgage with 3.5% interest, you'd lower your monthly payment to $640 for a savings of $60 per month and $720 per year.

Another benefit of refinancing is locking in a favorable rate when your current rate isn't set in stone. Some people take out adjustable rate mortgages, which are mortgages whose interest rates keep changing, because they offer low rates up front. Often, what happens with an adjustable rate mortgage is that you'll start out with a lower monthly payment, but over time, your interest rate will increase, and so will your monthly payment amount. Refinancing from an adjustable rate mortgage to a fixed mortgage can be a smart move at a time when interest rates drop across the board.

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Another reason people choose to refinance is to switch from a 30-year mortgage to a 15-year mortgage. While doing so won't necessarily lower your monthly payment, 15-year mortgages typically offer lower interest rates than 30-year mortgages, and that helps homeowners pay off their loans more quickly.

Drawbacks of refinancing

While there are certain benefits to refinancing, there are also some drawbacks -- namely, the costs involved. Just as most people pay closing costs on their homes, they are required to pay closing costs when they refinance their mortgages. From loan origination fees to appraiser fees, the costs of refinancing can really add up, sometimes to the point where they negate or exceed the financial benefits of getting a new home loan in the first place. This risk exists in particular if you refinance but don't plan to remain in your home for very long afterward.

Using our example above, let's say that refinancing your mortgage lowers your monthly payment from $700 to $640 for a $60 savings each month, but that you're also required to pay $3,000 in up-front closing costs. In this case, it would take you 50 months, or just over four years, to break even and start reaping the benefits of a lower interest rate.

If you're thinking of refinancing your mortgage, your best bet is to run the numbers, see how much you stand to save, and figure out whether those savings are worth the up-front investment. The higher your closing costs, the longer it will take you to recoup that initial expense, so make sure refinancing makes sense before you sign on the dotted line.

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