What does refinancing a home loan mean?

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Refinancing a home loan refers to the process of taking out a new mortgage to cover the outstanding balance on a previous mortgage. Refinancing is done in order to lower monthly mortgage payments or to extract equity from a property. Regardless of the reason for refinancing, interested homeowners should carefully weigh the pros and cons of refinancing their home loan.

The Advantages of Refinancing

The most notable advantages of refinancing include reducing monthly payments and extracting equity from a property for large purchases or home improvements.

For those interested in reducing their monthly mortgage payments, refinancing can help by changing the following on a home loan:

  • Interest rates
  • Term (duration)
  • Type (fixed or adjustable rate)
If a homeowner is able to refinance a home loan at a lower interest rate than their original mortgage, they will likely benefit by seeing reduced monthly payments.

For instance, imagine a person who financed their home 10 years ago at that year’s average interest rate. In 2002, average mortgage interest rates hovered between 6 percent and 7 percent. For the sake of this example, let’s take the middle ground and say our homeowner financed $200,000 at 6.5 percent with a 30-year fixed-rate mortgage. Given those figures, this homeowner would currently be paying $1,264 every month.

But if our fictitious homeowner decides to seek a refinance at the historic low interest rates we’ve been seeing over the course of 2012, he could reduce that monthly payment significantly.

Assuming this homeowner was able to score a home refinance loan for an identical amount but instead at 3.5 percent, he would see his monthly payments fall to $898.

That’s a savings of $366 every month, which equates to nearly $4,400 each year.

These savings often become even more pronounced when homeowners who originally took out an adjustable rate mortgage (ARM) refinance into a fixed-rate mortgage. This is because ARMs usually come with “teaser rates” that look great for the first few years, but then they “adjust” into a different number—one that’s usually not very favorable. It’s precisely due to that reason that more than 95 percent of refinancers choose fixed-rate mortgages.

But acquiring a lower monthly payment isn’t necessarily a homeowner’s only motivation for refinancing. Home refinance loans are great for extracting equity out of a property.

Equity refers to the value of a property above the outstanding balance of the home loan securing that property. For instance, if a homeowner owes $50,000 on a property worth $200,000, that property has equity worth $150,000.

Imagine a scenario where that same homeowner wishes to purchase a built-in pool for his backyard. He finds a pool contractor and is told it will cost him $20,000 for the pool he wishes to have built. He can fund that purchase by refinancing his outstanding $50,000 mortgage for $70,000. He takes out a new home loan for $70,000, pays off his original mortgage worth $50,000, and is left with $20,000 in equity to put towards the purchase of his pool.

That’s the power of home refinance loans: they allow homeowners to reduce their monthly payments and withdraw stored up equity.

The Disadvantages to Refinancing

But there are a few potential disadvantages to refinancing that homeowners ought to be aware of.

First and foremost, if an original home loan has any sort of prepayment penalty, homeowners should be very wary of paying it off early. Prepayment penalties are often included by lenders so that lenders can ensure they’ll see a certain amount of interest payments before a home loan is paid back. Prepayment penalties come in the form of a large fee if a homeowner decides to pay off a mortgage loan earlier than an agreed-upon date.

Additionally, home refinance loans come with all of the regular costs of a normal mortgage. That means homeowners will be expected to pay origination fees, inspection fees, appraisal fees, and more. Each of those costs should be put against the “savings” a homeowner will incur by refinancing, but if the pros still outweigh these extra costs, then refinancing may be a good idea.