How does refinancing work?
Refinancing works by giving a homeowner access to a new mortgage loan which replaces the existing one. The details of the new mortgage loan can be customized by the homeowner, include the new loan’s mortgage rate, loan length in years, and amount borrowed. Refinances can reduce a homeowner’s monthly mortgage payment, access cash for home improvements, and cancel mortgage insurance premiums, among other uses.
What is a mortgage refinance?
A mortgage is a loan used for real estate. They’re available via banks, credit unions, and online lenders. Hundreds of billions of dollars worth of mortgage loans are given each year.
But, mortgages aren’t one-size-fits-all. Mortgages can be customized.
For example, you can choose the number of years in your loan (i.e. term); you can choose the nature of your interest rate (i.e. fixed-rate or adjustable-rate); and, you can even choose what you pay in mortgage closing costs.
Your needs as a homeowner today, though,may be different from your needs tomorrow. In the future, you may not like mortgage terms you created for yourself.
Thankfully, there’s an option to change your mortgage loan terms. It’s known as a “refinance.”
To refinance your home means to replace your current mortgage loan with a new one. Refinances are common whether current mortgage rates are rising or falling, and you can get one from any bank you choose.
You’re not limited to working with your current mortgage lender.
Some of the reasons homeowners refinance include a desire to get a lower mortgage rate; to pay their home off more quickly; or, to use their home equity for paying credit cards or funding home improvement.
Refinances typically close more quickly than a purchase mortgage loan and can require far less paperwork.
3 types of refinance mortgages
Refinance mortgages come in three varieties — rate-and-term, cash-out, and cash-in. The refinance type that’s best for you will depend on your individual circumstance.
Refinance mortgage rates vary between the three types.
In a rate-and-term refinance, the only terms of the new loan which differ from the original one are either the mortgage rate, the loan term, or both.
Loan term is the length of the mortgage.
For example, in a rate-and-term refinance, a homeowner may refinance from a 30-year fixed rate mortgage into a 15-year fixed rate mortgage; or, may refinance from a 30-year fixed rate mortgage at 6 percent mortgage rate to a new, 30-year mortgage rate at 4.5 percent.
With a rate-and-term refinance, a refinancing homeowner may walk away from closing with some cash, but not more than $2,000 in cash.
“No cash out” refinance mortgages allow for closing costs to be added to the loan balance, so that the homeowner doesn’t have to pay costs out-of-pocket.
Most refinances are rate-and-term refinances, especially in a falling mortgage rate environment.
In a cash-out refinance, the refinance mortgage may optionally feature a lower mortgage rate than the original home loan; or shorter loan term, such as moving from a 30-year mortgage to a 15-year mortgage.
However, the defining characteristic of a cash-out mortgage is an increase in the amount that’s borrowed.
With a cash-out refinance, the loan balance of the new mortgage exceeds than the original mortgage balance by five percent or more.
Because the homeowners only owes the original amount to the bank, the “extra” amount is paid as cash at closing, or, in the case of a debt consolidation refinance, directed to creditors such as credit card companies and student loan administrators.
Cash-out mortgages can also be used to consolidate first and second mortgages when the second mortgage was not taken at the time of purchase.
Cash-out mortgages represent more risk to a bank than a rate-and-term refinance mortgage and, as such, carry more strict approval standards.
For example, a cash-out refinance may be limited to a lower loan size as compared to a rate-and-term refinance; or, may require higher credit scores at the time of application.
Most mortgage lenders will limit the amount of “cash out” in a cash-out refinance mortgage to $250,000.
Cash-in refinance mortgages are the opposite of the cash-out refinance.
With a cash-in refinance, a refinancing homeowner brings cash to closing in order to pay down the loan balance and the amount owed to the bank.
The cash-in mortgage refinance may result in a lower mortgage rate, a shorter loan term, or both.
There are several reasons why homeowners opt for cash-in refinance mortgages.
The most common reason to do a cash-in refinance to get access to lower mortgage rates which are only available at lower loan-to-values. Refinance mortgage rates are often lower at 75% LTV, for example, as compared to 80% LTV.
Another common reason to cash-in refinance is to cancel mortgage insurance premium (MIP) payments. When you pay down your loan to 80% LTV or lower on a conventional loan, your mortgage insurance premiums are no longer due.
Refinances require paperwork (but not so much)
When you do a mortgage refinance, you are establishing a brand-new loan with brand-new terms. Typically, this subjects a refinance applicant to the same mortgage approval process as with a purchase mortgage applicant.
In other words, the refinance applicant is evaluated in three specific areas:
- Credit Score and Payment History
- Income and Employment History
- Retirement Assets and Cash Reserves
Furthermore, also like a purchase, the home being refinanced is subject to a home appraisal in order to affirm its current market value.
Despite the similarities, though, borrowers can usually expect to provide less documentation for a refinance mortgage as compared to a purchase.
You will still be asked to provide proof of income using W-2s and pay stubs; proof of assets via bank statements; and proof of citizenship or U.S. residency status. But, you will not be asked to provide information related to the original transfer of the home.
Refinance mortgages are often ready to “close” in 30 days or fewer.
Some refinances don’t require verification
Refinance mortgages typically require the verification of a borrower’s income, assets, and credit. However, there are certain refinance programs for which verifications can be bypassed.
These programs are called “streamlined” refinances. They’re called streamlined refinances because their underwriting requirements are grossly simplified and designed to be speedy.
With a streamline refinance, mortgage lenders waive large parts of their “typical” refinance mortgage approval process. Often, home appraisals are waived, income verifications are waived, and credit scores verifications are waived.
Some common types of streamlined refinances are:
- FHA streamline
- VA streamline
- High LTV Refinance
- USDA streamline
Different lenders may deploy different overlays for each of the streamlined programs, but the programs can be summarized as follows.
The FHA streamline refinance
The FHA Streamline Refinance is available to homeowners with an existing FHA mortgage. The FHA Streamline Refinance program waives all verifications and refinance mortgage rates are as low as with a standard-verification FHA-backed loan.
The FHA Streamline Refinance requires refinancing homeowners to save five percent or more on their mortgage payment; and, to show a history of on-time payments to their lender.
Cash-out refinance mortgages are not allowed via the FHA Streamline Refinance program.
The VA streamline refinance
The VA Streamline Refinance is available to homeowners with an existing VA-backed mortgage.
Officially known as the VA Interest Rate Reduction Refinancing Loan (IRRRL), the VA Streamline Refinance also waives income, asset, and credit score verifications.
Refinancing VA homeowners are required to demonstrate that the refinance mortgage will result in monthly payment savings, except for homeowners changing to a shorter loan term, such as from a 30-year mortgage to a 15-year mortgage; or, from an ARM to a fixed-rate loan.
Homeowners may not receive cash-out as part of a VA Streamline Refinance.
FMERR and HLRO
New high loan-to-value programs have been rolled out and the first homeowners to use them started to do so in January 2019.
The Freddie Mac Enhanced Relief Refinance (FMERR) allows homeowners with less than 3% equity to refinance if their loan is owned by Freddie Mac. Under traditional lending rules, you need more than 3% equity to refi. But this program allows homeowners with little equity — or even no equity — to take advantage of today’s low rates.
Fannie Mae’s High LTV Refinance Option is similar to Freddie Mac’s program. Homeowners with little equity or negative equity can refinance at today’s low rates.
Both options come with the possibility of reduced documentation, such as an appraisal waiver or limited income verification.
USDA streamline refinance program
The USDA Streamline Refinance Program is available to homeowners with existing USDA home loans. USDA loans are loans for homeowners in rural or suburban areas which allow for up to 100% financing.
The USDA Streamline Refinance Program does not verify income, assets or credit; and, homeowners using the program to refinance are limited to 30-year fixed rate mortgages and 15-year loans. ARMs are not allowed.
Cash-out refinance mortgages are not allowed via the USDA Streamline Refinance.