how refinancing works

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According to a new study in the Journal of Financial Economics, American homeowners missed out on $5.4 billion dollars because they didn’t refinance.

Just how does refinancing work? The process can seem confusing if you’re unfamiliar with it. But we’ve got the answers to all your questions in this handy guide.

Whether you’re looking to refinance your home, car, or student loans, understanding the advantages and risks will help you make a smart decision and improve your financial situation.

Take a deeper dive and learn how does refinancing work for you.

What is Refinancing?

Let’s start from the beginning and be clear on what refinancing is and is not.

In a nutshell, to refinance is to replace one loan with another one from a different lender. The newer loan pays off the balance of the prior one, theoretically with more favorable terms.

A refinance does not eliminate your debt. You will still owe the same principle amount you did before requesting the new loan.

However, it should be easier for you to handle your debt because of either a lower interest rate or an increase in the amount of time you have to repay it.

Likewise, refinancing doesn’t replace or eliminate the risk to any collateral you have to put up to secure the initial loan. Your collateral will still be at stake, and in some cases may be more in jeopardy, until your balance is paid off.

There are a lot of smart reasons to consider this option, but you’ll have to have a strong understanding of your financial reality to know how does refinancing work best for you.

Why Do People Refinance?

Refinancing a loan makes sense for a lot of situations. It may give you the time and financial freedom to enjoy a higher quality of life. Let’s look at some of the specific reasons why people choose to refinance.

Lower Payments

Trying to improve your monthly cash flow? Many people consider a refinance to lower their regular payments and free up more disposable income.

Extending the life of a loan doesn’t automatically mean that it will save you money over the long haul, however. The length of the new loan, as well as the new interest rate, will determine if you’re ultimately saving money and, if so, how much.

Use an online payment calculator to help determine whether or not you stand to benefit from refinancing.

Save Money

The major motivation behind refinancing is to ultimately save money. Whether you’re looking for short or long term savings depends on the financial bind you find yourself in.

Look for an interest rate that is lower than the one you’re currently paying. You could end up saving thousands of dollars over the lifetime of the new loan.

When evaluating how does refinancing work in your situation, consider the overall savings you stand to accumulate to see if it’s worth it.

Make Upgrades

How does refinancing work as an investment strategy? For the savvy homeowner, it can be quite rewarding.

Taking a second mortgage allows you to use the equity in your home to fund necessary repairs or make renovations. You’ll raise the value of your house and be able to enjoy your property more.

Consolidate Debt

If you have multiple loans, consolidating them into one could save you money, effort, and worry.

Having to make one payment on a date that’s convenient for you could help you gain control of your finances. Learn the ins and outs of debt consolidation to see if this option makes sense for you.

Shorten Loan Time

You may want to save money by paying off a loan faster. In this case, it’s worth considering if refinancing into a loan with a shorter payoff window makes sense for you.

If, for example, you refinance your home from a 30-year mortgage to a 15-year mortgage, you could save yourself a considerable amount of money on interest payments. Getting rid of your debt quickly makes sense if you’re able.

Before you consider making changes to your loan, evaluate whether it’s more advantageous to simply make extra payments on your existing one.

You’d still save money and, if for some reason you couldn’t pay as large an amount in a given month, it wouldn’t affect your credit as it might if you missed a payment on your refinanced loan.

Meet an Upcoming Deadline

If you have a loan due and know it will be a struggle to make the deadline, refinancing could be a smart option. You’ll give yourself more time to pay off your debt without worrying about incurring penalties or late fees.

Undertaking this plan may not save you money in the long run, as you’ll start paying a whole new round of interest. But if peace of mind is your main concern, consider how does refinancing work for you.

Change the Terms of Your Loan

You may benefit from a refinance if you can get more favorable interest rates or convert those rates from variable to a lower fixed one.

In some cases, you may be able to take advantage of a low introductory rate to shift your debt from a fixed rate to a variable one. If you’re able to pay off the balance before the rate spikes, you’d save money in this process.

Make sure you’re aware of the short term and long term costs of your new interest rate loan before committing to this switch.

How Does Refinancing Work?

By now you’ve carefully considered the pros and cons of refinancing your home, car, or student loan. But just how does refinancing work?

The process is straightforward, although it can be costly and time-consuming. You will search for a new lender, much the same as you did when acquiring the original loan.

It is crucial that you find the right lender for your financial situation or you risk doing more harm than good in refinancing.

Once you’ve signed the paperwork, your new lender will pay the balance on your previous debt and you’ll begin making payments to that lender until the new loan is paid in full, or you refinance again.

What Information Do I Need to Provide for a Refinance?

Many of the same documents you needed to secure the original loan will be required again. Expect to produce your credit report, W2-s, paystubs, bank statements, and proof of citizenship.

Your income and employment history, as well as other assets, will also be taken into consideration. If you’re refinancing your home, it will need to be appraised as well to assess its current market value.

What Should I Consider Before Refinancing?

The potential benefits of refinancing are numerous, but your financial reality will determine if it’s a worthwhile option for you. As you’re deciding how to proceed, make sure you’ve asked yourself (and answered) the following questions:

What are My Financial Goals?

You must have a clear sense of what you hope to gain when determining how does refinancing work for you. Otherwise, you’ll end up in a spiral of accumulating more debt with less of a path forward.

Is your main priority to pay down debt as quickly as possible? Are you looking to lower your monthly payments and free up more disposable income? Do you want to turn your home into a source of passive income by making guest-friendly upgrades?

Is My Credit Good Enough?

Every refinance approval starts with a credit check. You should know your credit score and resolve any disputed issues on your credit report before beginning the process.

This score will go a long way in determining the quality of the loan offer made to you. If refinancing is in your future, take steps now to improve your credit scorebefore you request.

How Long am I Planning to Remain in My Home?

Expect your home refinance to cost 3-6% of the loan amount. Depending on how long you’re planning on staying in your current property, it may not make financial sense to refinance.

Calculate how long it’ll take you to reach your break-even point and compare that number to how long you intend to remain in your home.

Likewise, if you’ve owned your home for a long time and are near the end of your original mortgage, a refinance may not make sense because of the costs you’ll incur.

How Much Equity Do I Have in My Home?

Your refinance rates and eligibility are determined in large part by your home’s equity. Unless you have at least 20% equity, you will not be able to request a new loan without private mortgage insurance. This added cost could make benefit of refinancing moot altogether.

For underwater homeowners curious how refinancing works for them, there’s hope. Check with your lender to see if you qualify for an FHA loan or other assistance through a government program.

Make Good Financial Decisions

Refinancing is a major decision that requires thought and planning. It’s important that you have people on your side to help you improve your financial situation so you can enjoy the life you were meant to.

Our goal is to be an objective, independent resource for you so you can make smart choices about loans, credit cards, or anything else you may find on our site.

Check out our blog to learn more, and leave us a comment so we can help you better in the future!