When you get a mortgage, a lender provides you with the funds to purchase a home and, in exchange, you agree to make regular payments as set out in your mortgage contract. But what if you want to lower your borrowing costs or access more money against your home equity?
In that case, mortgage refinancing is an option, as we explain below.
What it means to refinance a mortgage
Refinancing a mortgage is a financial strategy where you break your existing mortgage contract and pay the current balance in full by securing another mortgage loan. This new loan comes with its own terms and conditions, including a different interest rate than you had with the prior mortgage loan.
When you refinance, you may also be able to increase the size of your mortgage, depending on how much equity you’ve built up in the property. That’s because the loan you receive when you refinance a mortgage could be as much as 80% of the appraised value of your home.
For example, if your home is worth $500,000, you could borrow up to $400,000. If your previous mortgage balance was $350,000, you would receive the extra $50,000 as a lump-sum payment.
This method of borrowing is preferable to other types of debt, as mortgage interest rates are generally lower than other loans you may apply for either from a bank or private lender.
Reasons to refinance a mortgage
There are two main reasons why borrowers might want to refinance their mortgage:
- To lower mortgage borrowing costs. If interest rates drop significantly, refinancing could lower your monthly payments or allow you to pay down your mortgage sooner.
- To access home equity. You can tap into your home’s equity to pay for renovations, buy an income property, consolidate higher-interest debt, fund your child’s education, start a new business, or any other reason.
When to refinance your mortgage
The best time to refinance is at the end of your mortgage term, especially if you have a closed fixed-rate mortgage. That’s because if you refinance on a closed mortgage before your term is up, you’ll be charged a prepayment penalty. The penalty usually isn’t too steep on a variable-rate mortgage (typically three months interest) but can be much larger on a fixed-rate mortgage, especially if there’s lots of time remaining on the term.
If you wait until the end of the term to refinance (or if you have an open mortgage), you can side-step these prepayment fees entirely.
As far as refinancing your mortgage mid-term, it really comes down to whether the benefits outweigh the costs. If you’re wondering if the time is right to refinance your mortgage, ask yourself the following questions:
- What’s your existing mortgage rate against other rates available in the market?
- What are the legal and closing costs (e.g., appraisal, title search, and title insurance fees) associated with refinancing your mortgage?
- Are you consolidating high-interest debt?
- How much is the penalty cost (if any) for breaking your mortgage?
- Would refinancing greatly improve your everyday life? For clarity, consider rating the peace of mind you would get by refinancing from one to 10.
How to refinance a mortgage
If you decide to pull the trigger on refinancing your mortgage, fill out your application and make sure you gather all the relevant documentation the lender will need to evaluate your eligibility. Approach each lender and ask them for a list of documents you will need, including proof of income and tax documents. This is where it helps to have a mortgage broker who can help facilitate the gathering of these documents and submit your application for you.
If you get approved, don’t just sign immediately. You should read the terms and conditions carefully, especially the details related to costs, payments and interest rate. Ask for clarity if there’s anything you don’t agree with or don’t understand.
A mortgage broker may be able to help here and negotiate on your behalf, but it’s perfectly acceptable to negotiate directly with the lender yourself. After all, a percentage point off your interest rate may give you just enough wiggle room to be able to better afford the closing costs.
Alternatives to mortgage refinancing
If the costs of refinancing are prohibitive, there are a few other options you can consider:
- Blend and extend. Some lenders allow you to renegotiate your interest rate before the end of your mortgage term through a blend-and-extend option. This allows you to extend your existing mortgage term at a lower rate by blending the new lower interest rate with the old one while avoiding prepayment fees.
- Apply for a HELOC. You can borrow against the equity in your home through a home-equity line of credit (HELOC). To be eligible, you must hold at least 20% equity in your home, and the maximum credit limit is 65% of the home’s market value. You can get a HELOC in addition to your existing mortgage, which means you don’t have to break your mortgage or pay prepayment penalties. Interest rates on a HELOC will typically be higher than what you could get on a mortgage refinance.
- Get a second mortgage. A second mortgage is another way to access the equity in your home. It is issued on top of your primary mortgage, which avoids prepayment fees. However, interest rates are higher than a mortgage refinance or HELOC.
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