Refinancing 101: What are my Options?

If you're a homeowner, you've probably been hearing a lot about how low mortgage rates are these days. But even with all the news coverage and advertising, you might not know what refinancing is, or what your options are.

What is a Mortgage Refinance?

When you first bought your home, you took out a mortgage to pay for it, with terms that specified the interest rate and length of time for repayment. But, as interest rates drop or your life situation changes, it's possible that those original terms are no longer right for you.

To put it simply, refinancing a mortgage loan involves paying off an existing mortgage with a new mortgage, with new terms that better meet a borrower's current needs.

A refinance could lower your monthly payments and save you a substantial amount of money over the life of your loan, especially if your original mortgage dates back to the early 2000s, when interest rates were significantly higher. It could also give you access to cash to help you finance a big project, such as a home renovation.

If you're considering a refinance, here are the two main options you might consider:

A Cash Out Refinance

A cash out refinance lets you get a new mortgage for more than your current mortgage balance—based on the additional equity you've built up in your home since buying it. You pay off your existing mortgage, and are then able to use the extra money for whatever you'd like—home renovations, debt consolidation, medical bills, educational expenses, etc.

You can only do this if your loan amount falls below the loan-to-value (LTV) threshold set by your banker, so you will not be able to borrow more than your home is worth.

If you want to get an estimate of what kind of cash out you might be able to qualify for, divide your current mortgage balance by the current value of your home. Say your home is valued at $500,000, and you still owe $300,000. That gives you a LTV ratio of 60 percent. Lenders generally allow cash out refinances of up to 80 percent LTV, which means you may be able to refinance for up to $400,000, giving you access to about $100,000 in cash. (However, it's usually a good idea to tap only the amount of money you actually need, to avoid over-borrowing.)

Cash out refinances can be a great way to borrow money, because the interest rate is usually much lower than with personal loans or credit cards.

A Rate and Term Refinance

With a rate and term refinance, you pay off the balance of your mortgage with a new one that has a lower interest rate. In the process, you might also want to change the loan term, which is the number of years it will take to repay your loan.

The main reason you might want to do this is to save money—either in the short-term, the long-term.

For example, you might want to replace your 30-year mortgage with a 15-year mortgage that has a lower interest rate and helps you save money over the life of the loan.

Or maybe you're interested in reducing the size of your monthly payments. Say you've got 20 years left on your 30-year mortgage. You could refinance with another 30-year term, and spread out the balance over a longer period of time with smaller monthly payments. Using this option may involve paying more in interest over the long term, plus closing costs, but, depending on your financial priorities, it could still make a lot of sense.

If you currently have an adjustable-rate mortgage, it may also be worth thinking about converting to a fixed-rate mortgage, while interest rates are at or near historic lows. Rates will inevitably rise again at some point, but with a fixed-rate mortgage, you'll have the peace of mind of knowing that your monthly principal-and-interest payments won't.

Now that you know the most common refinancing options available to you, it's time to discuss some of the main benefits you can unlock by refinancing. Check out our next blog, "Why It's Time to Consider Refinancing" to learn more.