How Does Refinancing Work - How Can You Save by Refinancing

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If you are looking to save money, refinancing may be just what you need. Let's see how does refinancing work.

When you refinance, you simply pay off one loan with another. The reason you do this is because the new loan terms are more favorable than the previous. Even though it costs money to refinance, the main reason for refinancing is to save money (over the long term).

There are many ways you can save money by refinancing your mortgage.

- By replacing your current mortgage with a loan with a lower interest rate, you save money monthly and over the course of the loan.

- By changing the term or length of your loan, you can lower your monthly payments.

- If you have enough equity in your home, you can consolidate your all your bills into one payment and stretch the total out over the course of your loan which will in most cases drastically reduce the amount you pay monthly.

When is it worthwhile to refinance? It doesn't make sense for everyone but if you follow the rule of thumb you have a pretty good chance of saving money. If you're just looking to lower your interest rate, consider refinancing when advertised interest rates are 1.5 to 2% lower than your current rate. Because of how refinancing works, you should plan to stay in your house another 3 years to really reap the benefits of a lower interest rate.

Some other reasons to refinance include:

- Change to a fixed rate. Your adjustable rate mortgage (ARM) may soon become unmanageable. If you refinance you wont have to worry about how much your payments will be as the rates continue to adjust.

- Build up equity quicker. If you have a substantial increase in disposable income, you can reduce the term of your loan. Your payments will be higher but you'll be paying off the principal quicker.

- Do a cash out refinance. Use the equity in the home to pay for a major purchase or college education.

What Are The Costs of Refinancing

When you're asking about how does refinancing work, you have to think about the costs that go along with it. Plan on paying about 3-6% of your principal in refinancing costs, plus any prepayment penalties. In order to keep clients from refinancing often, many companies will include a prepayment penalty. Your mortgage documents will clearly state if you have a prepayment penalty - although it may not clearly state how much it is. It is up to you to determine if it is worth it to refinance with these costs. Many times the refinancing lender will roll the costs into the loan so you don't have to pay so much up front. Just be aware that you will be paying these costs, and actually more because you now have interest on top of it.

The Definition of Home Equity

Before considering a home equity loan or line of credit, it's important to understand the definition of home equity and what it means for your loan. In its simplest terms, equity is defined as the difference between the current value of your home and how much is left on your mortgage.

Let's say your house has increased in value by $75,000 since you first bought it. If you haven't paid any of your mortgage principal down (which you probably have unless you have an interest-only loan), this increase in value represents $75,000 which you can borrow against.

Similarly, if you have paid off $15,000 in principal from your mortgage, this is also home equity. Remember, however, that mortgage payments consist of both interest and principal and in the early years of your mortgage the monthly payments is mostly interest. So if you have not had your mortgage very long you may not have paid down as much principal as you might expect. Check your monthly mortgage statement to see how much principal has been paid.

So in this example, if the price of your home has increased by $75,000 and you have paid off $15,000 in mortgage principal, you have built up $90,000 in home equity. This is the definition of home equity in action.

However, that doesn't mean you can go to a bank for a $90,000 loan. The amount you can borrow is determined by what is known as the "loan-to-value" ratio. The loan-to-value ratio tells you how much of your home equity you can tap into.

Since banks need to protect themselves, they won't let you use all the equity you may have available in your house. Banks examine your annual income, credit rating, and the amount of your outstanding debt when determining how much to lend you. Most lenders won't go higher than 80-85% of the appraised value of your house minus what's left on your first mortgage.