Should You Refinance Your Mortgage?

A mortgage refinance involves the closing of one home loan and the beginning of another. It can be a good option in some situations, but it is not for everyone.

You should consider a mortgage refinance if you can get a lower interest rate, a longer or shorter repayment period, or a larger loan than you have now.

Remember that refinancing your mortgage involves paying closing costs, which can be costly if you are cancelling your current mortgage. Be sure to consider whether the savings from the refinance will outweigh these costs.

What is a Mortgage Refinance?

When you refinance your mortgage, you basically replace your current mortgage with a new home loan, usually from a different lender. Most people refinance their mortgage to lower their interest rate, but the new loan may also have a different term — for example, switching from a 30-year term to a 15-year term mortgage.

Mortgage refinancing can help you lower your monthly payments, save money over the life of your loan, pay off the loan faster, and gain access to equity in your home.

When you refinance a mortgage, the first mortgage is paid off (making way for a new loan) rather than creating a new mortgage and discarding the old one.

Refinancing can be a smart way for borrowers with an excellent credit history to get a lower interest rate or switch from a variable rate to a fixed rate. Refinancing can be risky for borrowers with a poor credit history.

Here's an example of how refinancing can save money over the life of the loan:

Joshua takes out a 30-year fixed mortgage at 3.57%. However, due to slow economic growth, the interest rate falls to 2.90% a year later. In this case, refinancing the mortgage may assist Joshua in lowering his monthly payments.

Of course, the equation is not always as simple as the difference between the old and new interest rates. Other factors, such as the mortgage prepayment penalty, can influence whether refinancing a mortgage makes financial sense. Note: don't forget about protecting your new mortgage.

How Much Does it Cost to Refinance a Mortgage?

You can refinance a mortgage before its term is over. Or, you can refinance it at the end of its term. In either case, you  have to pay various fees. 

Whether you refinance the loan within its term or at the end of it, you will need to pay mortgage registration fees, legal fees, and home appraisal fees. Refinancing the loan before the end of term involves two additional charges: prepayment penalty and mortgage discharge fees. You can avoid mortgage discharge fees by staying with your current lender. 

These fees can add up depending on when you refinance your mortgage and the size of your loan. 

• Legal Fees

Legal fees involved in the refinancing process may set you back by $700-$1,000. If your mortgage balance exceeds $200,000 and you are changing lenders, the new lender may agree to pay these fees. 

• Home Appraisal

A home appraisal is a process through which an unbiased appraiser determines the fair value of a property. When you apply for a refinance, the lender will likely get your home appraised by a professional to decide how much money you can borrow. Generally, you can only borrow up to 80% of the appraised value of your property. 

The cost of a home appraisal depends on your city and locality, but you can expect to pay somewhere between $300 and $500. Usually, the lender is the one that hires the appraiser, even though the borrower is paying the bill.   

• Mortgage Registration

Mortgage refinancing involves replacing the existing mortgage with a new one. Therefore, the current mortgage amount must be removed and the new mortgage amount added to the title on your property. The cost of registering the new mortgage varies by province, but it is usually around $70. 

• Mortgage Discharge 

If you change lenders, you must pay for the mortgage discharge, a legal document that releases the collateral on your home. When you switch lenders, the current mortgage must be discharged and the new lender must be added to your property’s title. 

Lenders usually charge fees for a mortgage discharge. While each lender sets its own fees, some provinces cap the maximum amount lenders can charge for a mortgage discharge. The amount you pay to discharge your current mortgage depends on the lender and the rules of your province or territory, but it usually ranges anywhere between $200 and $350. 

• Mortgage Prepayment Penalty

A mortgage prepayment penalty is the amount of money you pay to the lender if you pay off the loan before the expiry of its term. 

One of the ways a mortgage lender makes money is by collecting the interest on the principal amount. If you prepay the mortgage, the lender collects fewer interest payments than it would have had you paid installments until the expiry date. To compensate for the loss, many mortgage contracts (but not all) include a provision called prepayment penalty. 

If your mortgage contract includes a prepayment penalty, it will likely be the largest cost that you will bear when you refinance. The size of the prepayment penalty depends on: 

• whether your mortgage has a fixed rate or a variable rate
• the type of mortgage you have
• the size of the mortgage
• when you refinance the mortgage
• the difference between your existing mortgage rate and the current rate.

If you have a variable rate mortgage, the prepayment penalty is usually three months’ interest. 

If you have a fixed rate mortgage, the prepayment penalty will be the greater of three months’ interest and the interest rate differential (IRD). 

You can refinance a mortgage at any time, but if you want to avoid the prepayment penalty, it's be best to wait until the term ends. Another way to circumvent the prepayment charges is to go for an option known as the blend and extend mortgage. 

You can choose to blend and extend the mortgage at any time without penalties, but keep in mind that your existing mortgage rate will influence your refinance rate to some extent. To be precise, the blended rate will fall somewhere between your current mortgage rate and the existing rate. 

For example, let us say your existing mortgage rate is 2.93%. The best rate you currently qualify for is 2.3%. If you choose the blend and extend option, your new rate will fall somewhere between 2.93% and 2.3%, as opposed to 2.3% that you will get if you pay the prepayment charges. 

In short, the blend and extend option helps you escape the hefty prepayment fee, but the new rate is higher than the current rate. 

Here is how much you can expect to pay for refinancing a typical mortgage in different scenarios: 

• $1,120-$1,920 for refinancing the mortgage with the same lender at the expiry of the mortgage term
• $1,120-$1,920 + prepayment charges for refinancing the mortgage with the same lender before its maturity date
• $1,320-$2,270 for refinancing the mortgage with a new lender at the expiry of the mortgage term
• $1,320-$2,270 + prepayment charges for refinancing the mortgage with a new lender before its maturity date.

Types of Mortgage Refinancing

There are different types of mortgage refinancing. Knowing all the options available to you and how they work can help you pick the one that works best for you. 

1. Rate-and-term refinance

This type of refinancing involves changing the interest rate, or the mortgage term, or both. A rate-and-term refinance can lower the size of your monthly mortgage installment or allow you to pay off the entire loan sooner or later than your current repayment term. 

2. Cash-out refinance

A cash-out refinance allows you to convert home equity into cash. The new mortgage is bigger than your previous loan, but it gives you money to fund a large expense or meet a financial emergency. The interest rate and the repayment period of the new loan can be different from those of the original loan. 

3. Cash-in refinance

A cash-in refinance involves making a large payment toward the principal to bring the loan-to-value (LTV) ratio down. This in turn can help you qualify for mortgage refinance or secure a lower interest rate.

Typically, you need 20% equity in your home to be approved for a mortgage refinance. What if your equity is less than 20%, but you want to refinance your home loan? In this situation, a cash-in refinance can be the solution.  

Let us say your home’s appraised value is $300,000 and the current mortgage balance is $270,000. That means the LTV ratio is 90%, which will likely put refinancing out of your reach. 

You can choose a cash-in refinance and make a payment of $30,000 to your lender to reduce the mortgage balance to $240,000. Since now the LTV ratio is 80%, you can easily get approval.  

Apart from helping to qualify for refinance, cash-in refinances can lower the interest rate because lenders offer better rates to borrowers with lower LTVs.  

4. No-closing-cost refinance

With a no-closing-cost refinance, you will not pay the closing costs upfront when you take a new loan. But that does not mean you will be able to avoid them entirely. The lender will wrap the closing costs into the new loan or approve you with a higher rate. Either way, you will pay a higher monthly installment. 

The no-closing-cost refinance option can be a good choice for someone who plans to stay in the home for a shorter period. 

5. Short refinance

A short refinance can be an option if you are at risk of foreclosure. The lender will give you a new loan that is smaller than the balance on your current mortgage and forgive the difference. But the downside is that your credit score will take a hit. 

6. Reverse mortgage

If you are aged 62 or older, you may be able to borrow money from the mortgage lender against the equity in your primary residence. You can use the money however you like, and it does not need to be repaid until you pass away or move out of the home. The loan itself is tax-free, but it accrues interest on a monthly basis. 

7. Debt consolidation refinance 

Like a cash-out refinance, a debt consolidation refinance lets you convert your home equity into cash. The cash can only be used to pay off other debts, like a car loan or credit card debt, instead of putting it into your pocket. Since mortgage rates are generally lower than those of other consumer loan products, consolidating all the debts into one payment can save you money in the long run. 

Why Refinance Your Mortgage?

Homeowners refinance their mortgages for several reasons. The most common ones are as follows: 

1. Lower interest rate

Have mortgage rates fallen since you took the home loan? Has your credit score improved considerably in the past few years? If so, a mortgage refinance may save you a few thousand dollars over the life on the loan, if not more. 

2. Change the mortgage term

Let us say you have a 30-year term on your current mortgage. This term looked right five years back, but since then your income has improved considerably and you would like to pay off all your debts as quickly as possible. In this situation, refinancing the mortgage to reduce the term to 15 years or even 10 years may be advantageous to you. 

If you are currently in a tight spot financially, increasing the mortgage term will lower your monthly installment. For instance, switching from a 15-year mortgage to a 30-year or 40-year mortgage can reduce the strain on your monthly budget.

Switching to a variable-rate mortgage is another option in this situation, if the current mortgage rates are lower than your existing rate and are likely to stay that way over the next few years.

3. Borrow more money

You can increase your mortgage debt by refinancing and can use the extra money to pay off debt, finance a large expense, buy out an ex-spouse in a divorce, or for any other purpose. Keep in mind that you typically borrow more money by refinancing only if your existing mortgage is less than 80% of the current value of your property.

For example, if your current mortgage amounts to 60% of your property’s value, you may be able to borrow 20% more. 

While mortgage rates are considerably lower than personal loan rates, you may eventually pay more money as interest because typically mortgage terms are longer. Rather than increase the home loan amount, it might be a better idea to prioritize and pay off the debts separately.  

4. To switch to a different loan type

You can refinance your mortgage to switch from a variable-rate mortgage to a fixed-rate one and vice-versa. A fixed-rate mortgage is one in which the interest rate remains the same throughout the term of the loan. On the other hand, a variable-rate mortgage, also known as adjustable-rate mortgage, fluctuates depending on your lender’s prime rate. 

5. Flexible mortgage features

Refinancing gives you access to flexible features lacking in your mortgage contract such as:

• the ability to pay back more than you need to (the surplus amount reduces both the principal outstanding and interest burden)
• the freedom to temporarily stop or reduce your monthly installments.

Keep in mind that added features such as these will increase your overall cost. 

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How Much Can I Borrow With a Mortgage Refinance?

Generally, lenders let borrowers draw out up to 80% of their home’s value when they refinance. But this can vary from one lender to another and may depend on your personal situation. Some private lenders may let you borrow more than 80% of your home’s value, but you will pay higher interest rates. 

How Do I Refinance My Mortgage?

Step 1: Define your financial goal for refinancing

You should know exactly why you are refinancing, whether it is to access home equity for debt repayment or a home renovation project or to lower the monthly installment by securing a better rate or switching to a longer term.

Step 2: Check your credit score

Just as you needed to qualify for your first mortgage, you will need to get approval for refinancing. While the minimum credit score for refinance varies by lender and loan type, generally a score of 620 and thereabouts is good enough. Of course, the higher your score, the lower rates mortgage lenders will offer you. 

Step 3: Calculate your home equity 

To determine your home equity, divide what you owe to the mortgage lender by your home’s current market value. For example, if your house is worth $500,000 and your current mortgage balance is $125,000, your home equity is 25%. Most lenders will offer you better rates if you have 20% or more equity in your home. 

Step 4: Shop around

Compare as many mortgage rates and offers as possible, but it would be wise to start with your existing lender. Since you are already a customer, it may offer you a special deal or discount that could result in significant savings. 

Step 5: Negotiate the closing costs

If you are breaking the existing mortgage, the closing costs can be pretty high. Speak to your lender to check if they are willing to lower them, especially if you have multiple refinance offers in hand. 

Step 6: Get all the paperwork in order

Your lender will tell you all the documents you will need to submit. Make sure you have them ready when you fill out the refinance application. 

Step 7: Prepare for the home appraisal 

Your mortgage lender will typically have your home appraised by a professional to determine its current value. 

Should I Refinance my Mortgage?

Refinancing can be a money-saving option in some situations. You may want to consider it if: 

• you can reduce your monthly installment by securing a better interest rate or increasing the repayment period
• you will pay less interest in the long run because of a lower rate, a shorter repayment period, or both
• you will save money in the long run by consolidating all your debts (student loan, credit card debt, car loan, etc.) into one payment.

As you evaluate all the available options, factor in the closing costs that you will need to pay if you are refinancing before your existing mortgage’s expiry date. These costs, which include the prepayment penalty, appraisal fee, legal fees, and more, can be as high as 2-5% of the loan amount. Refinancing makes financial sense only if your savings exceed the closing costs.   

Alternatives to Refinancing Your Mortgage

If you need access to a lump sum amount of cash, a home equity line of credit (HELOC) is worth considering. A HELOC is a secured form of credit that uses your home as collateral. Like a mortgage refinance, it allows you to draw up to 80% of your home’s market value, but there are some key differences between the two. With a HELOC, you can borrow multiple times without worrying about paying fees each time.

This makes it an attractive option for homeowners looking for a loan that is easily accessible.  

HELOC rates are typically higher than mortgage refinance rates, though they are lower than credit card rates. Also, HELOC rates are always variable, meaning they can change from month to month. In contrast, mortgage refinance rates can be either fixed or adjustable. 

A home equity loan is another alternative to refinance. Also known as an add-on mortgage or a second mortgage, it lets you borrow against your home. You can borrow up to 80% of your home’s value, minus the outstanding balance on your primary mortgage. Since your home acts as collateral for both the primary and secondary mortgage, you risk losing it if you fail to pay either of them. 

Home equity loans are generally recommended for expenses that may increase your home’s overall value, like a renovation project. However, you may also consider it if you need cash for a major expense, like funding a child’s college education, or want to consolidate credit card debt. 

Does Refinancing Have an Effect on my Credit?

Whenever you refinance your mortgage, your credit score will dip slightly in the short-term. That is partly because of the hard inquiry on your credit run by the lender and partly because you have acquired additional debt without yet having proved your ability to handle it. However, if you pay the monthly installments on time, soon your credit score will be back to where it was. 

Conclusion

A mortgage refinance is when you close your existing home loan and take up a new mortgage. You can refinance with your current lender or a new one. Whether it is right for you or not depends on your situation. If refinancing will result in a smaller monthly installment or help you pay off the debt quickly, it is worth considering. You may also want to consider it if you need access to cash and your existing mortgage is less than 80% of your home’s value.