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How Does Refinancing Work?

In the world of mortgages, the term “financing” refers to borrowing money from a bank to help pay for a property.

If then, at a later date, the homeowner wishes to replace his mortgage with a new one — one with either a lower mortgage rate, for example, or one that provides cash-out at closing — the financing process is repeated.

This repeat is called a “refinance”. Refinancing is when you obtain a new mortgage loan to pay off and replace an existing one.

Refinances Require Re-Verification

Because a refinance amounts to establishing a brand-new loan with brand-new terms, it follows that refinance applicants are subject to the same approval process as for the initial mortgage which was given at the time of purchase. A refinanced mortgage represents a brand-new debt and must be underwritten accordingly.

As with a home purchase, there are three basic areas against which a refinance applicant is evaluated :

  1. Credit Score and Payment History
  2. Income and Employment History
  3. Retirement Assets and Cash Reserves

Furthermore, the home being refinanced is subject to an appraisal to determine its current value.

Next, the above traits are compared against today’s mortgage standards. If both the refinancing household and the home itself meet current mortgage guidelines, the refinance will be approved and the old loan will be replaced.

3 Types Of Mortgage Refinance

Mortgage refinances come in three varieties — rate-and-term, cash-out, and cash-in. The refinance type that’s best for you will depend on your individual circumstance.

Rate-And-Term Refinance

In a rate-and-term refinance, the only terms of the new loan which differ from the original one are either the mortgage rate, the loan term, or both. Loan term is the length of the mortgage. For example, in a rate-and-term refinance, a homeowner may refinance from a 30-year fixed rate mortgage into a 15-year fixed rate mortgage; or, may refinance from a 30-year fixed rate mortgage at 6 percent mortgage rate to a new, 30-year fixed rate mortgage at 4 percent.

With a rate-and-term refinance, a refinancing homeowner may not walk away from closing with more than $2,000 in cash. Closing costs and escrow reserves may be added to the loan balance.

Cash-Out Refinance

In a cash-out refinance, the new mortgage may have a lower mortgage rate or shorter term as compared to the original home loan. However, the defining characteristic of a cash-out mortgage is that the loan balance of the original mortgage is increased to account for cash-in-hand at closing of more than $2,000; for debt consolidation; or, to combine an existing first and second mortgage.

Cash-out mortgages represent more risk to a bank than a rate-and-term refinance and, as such, carry more strict approval standards. For example, a cash-out refinance may be limited to a lower loan size as compared to a rate-and-term refinance; or, may require higher credit scores from the applicant.

Cash-In Refinance

With a cash-in refinance, a refinancing homeowner brings cash to closing in order to pay down the loan balance. The refinanced mortgage may also have a lower mortgage rate, or a shorter loan term, or both. There are several reasons why homeowners opt to do a cash-in mortgage, but the most common reason is to get access to lower mortgage rates which are only available at lower loan-to-values, or to remove mortgage insurance payments for loans over 80% LTV.

A mortgage at 75% loan-to-value, for example, may get better rates than a mortgage at 80% loan-to-value, and conforming loans under 80% LTV pay no PMI.

“Special” Refinance Programs For Homeowners

With respect to refinancing, there are four mortgage programs for which the mortgage approval process is different. Collectively, these programs are known as “streamline” programs because their respective underwriting requirements are grossly simplified.

With a streamline refinance, lender often waive large chunks of the “typical” mortgage approval process which may include waiving appraisals, waiving income verification, and waiving credit score minimums.

Four common streamline refinance programs are :

  • FHA Streamline Refinance : For homeowners with an existing FHA mortgage
  • VA Interest Rate Reduction Refinancing Loan (IRRRL) : For homeowners with an existing VA mortgage
  • Home Affordable Refinance Program (HARP) : For homeowners with an existing Fannie Mae or Freddie Mac mortgage
  • USDA Streamline Refinance : For homeowners with an existing USDA mortgage

Streamline refinances are available via any lender and mortgage rates are the same as with “traditional” refinances.