What is Refinancing? When Should You Refinance?
Refinancing is the process of replacing an existing loan with a new one. This can be done for a variety of reasons, such as to get a lower interest rate, change your loan amortization or obtain a different payment structure.
Why Refinance?
There are many reasons why people refinance their mortgages. Some of the most common reasons include:
To get a lower interest rate: This is the most common reason people refinance their mortgages. If interest rates have decreased since you took out your original loan, then refinancing can save you money on your monthly payments and over the life of the loan.
To change the loan amortization: This can also save you money on interest because you will pay less interest over the life of the loan. For example, if you refinance from a 25-year mortgage to a 15-year mortgage, you will pay off your loan 10 years sooner and save thousands of dollars in interest. You can also increase your mortgage term. For example, you might increase it from 20 years to 30 years to reduce your monthly payment.
To get a different payment structure: For example, you may want to switch from a fixed-rate mortgage to an adjustable-rate mortgage (ARM). ARMs typically have lower initial interest rates than fixed-rate mortgages, but the interest rate can fluctuate over time. Some people refer to ARMs as variable-rate mortgages. Although they are similar, they are slightly different. An ARM's payment will fluctuate, whereas a variable rate payment remains the same.
To get cash out: If you have built up equity in your home, you may be able to refinance and take out some of the equity in cash. This can be used for a variety of purposes, such as paying for home improvements, debt consolidation, or college tuition.
To consolidate debt: If you have other debts, such as credit card debt, you may be able to refinance your mortgage and combine all of your debts into one loan. This can make it easier to manage your finances and save money on interest.
How Does Refinancing Work?
The process of refinancing a mortgage is similar to the process of getting a new mortgage. You will need to provide the lender with information about your income, assets, debt, and credit score. The lender will then use this information to determine whether you qualify for a refinance and what interest rate you will be offered.
Once you are approved for a refinance, the lender will pay off your old mortgage, and you will start making payments on the new one. The closing costs for a refinance are generally lower than those for a purchase. You'll generally have to pay a $300-$500 appraisal cost, along with hiring a lawyer to complete the legal aspects of the refinance. Lawyers generally cost anywhere from $1,000-$3,000.
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When Should You Refinance?
Not everyone should refinance their mortgage. There are a few factors to consider when deciding whether or not to refinance, such as:
The current interest rate: If interest rates are lower than your current interest rate, then refinancing could save you money. However, it is important to factor in the closing costs when making this decision. If you have a fixed payment term, you may have a large pre-payment penalty. To calculate your prepayment penalty, download our refinance calculator from our Mortgage Master Kit here.
The length of time you plan to stay in your home: If you plan to move in the near future, then refinancing may not be worth it, as you may not have enough time to recoup the closing costs.
Your financial situation: If you have other debts that you need to pay off, then refinancing may be a good option for you because you might be able to consolidate those debts and reduce your overall monthly payment. To calculate your potential savings, download our debt consolidation calculator from our Mortgage Master Kit here.
Your credit score: You will need a good credit score to qualify for a refinance with a bank. If your credit score is low, your best option would be to reach out to your local mortgage broker because they work with lenders who allow lower credit scores.
Example Scenarios
Example Scenario 1: Refinancing to Secure a Lower Interest Rate
Let's consider Sarah, a homeowner who purchased her house two years ago when interest rates were significantly higher than they are today. At that time, she obtained a 5-year fixed-rate mortgage with an interest rate of 5.5%. Sarah has been making her monthly mortgage payments faithfully, but she recently learned that interest rates have dropped significantly since she secured her original loan.
Sarah decides to explore the option of refinancing her mortgage to take advantage of these lower rates. After some research and shopping around, she found a lender willing to offer her a 5-year fixed-rate mortgage at an interest rate of 3.5%. Here's how this scenario plays out:
Monthly Savings: By refinancing to the lower interest rate, Sarah's monthly mortgage payment decreases significantly. Her original monthly payment was $2,456.35, but with the new loan, it drops to $2,002.49
Total Interest Savings: Over the life of the loan, Sarah stands to save a substantial amount in interest payments. With her original loan, she would have paid a total of $336,904.99 in interest. However, with the refinance, she will only pay $200,748.28 in interest. She would have, therefore, saved 136,156.71 over the lifetime of the loan. It should be mentioned that these are only 5-year terms, and the life of the loan is 25 years. The interest rate must be assumed over the lifetime of the loan because we can't predict where interest rates in the future.
In this scenario, Sarah's decision to refinance into a lower interest rate results in significant monthly savings and substantial long-term interest savings.
Example Scenario 2: Refinancing to Consolidate Debt
Now, let's explore a different scenario involving John and Mary, a couple who have been homeowners for ten years. Over the years, they have accumulated various types of debt, including credit card balances, personal loans, and a car loan. The interest rates on their debts average to 12.99%, and the balance is approximately $75,000. The increased payments added up to $811.87/month. This made it challenging to manage their monthly payments and save money for everyday expenses.
John and Mary ended up using the monthly budget calculator from our Mortgage Master Kit and decided enough was enough. They eventually made the decision to investigate the option of refinancing their mortgage to consolidate their high-interest debt. They've built up substantial equity in their home, and they believe this equity can be used to pay off their other debts at a lower overall interest rate. Here's what happens:
Cash-Out Refinance: John and Mary work with a lender to perform a cash-out refinance. They refinance their mortgage and take out an additional $75,000 in cash, which they use to pay off their credit card balances, personal loans, and car loan. The new mortgage balance is higher due to the cash-out component, but they now have a single, lower-interest loan to manage.
Monthly Savings: By consolidating their debts into the mortgage, John and Mary benefit from lower monthly payments. The interest rate on their new mortgage is significantly lower than the rates on their previous debts, resulting in more manageable monthly expenses. The new loan was t 6% and only cost $483.23/month, saving them $328.64/month.
Simplified Finances: Managing one mortgage payment is more straightforward than juggling multiple high-interest debt payments. John and Mary find it easier to budget and make timely payments.
Potential Interest Savings: While they may pay more in interest over the long term due to the extended mortgage period, John and Mary still save money in the short term by reducing their monthly interest expenses on the consolidated debt.
In this scenario, John and Mary's decision to refinance their mortgage to consolidate high-interest debt allows them to simplify their finances, lower their monthly payments, and regain control of their financial situation.
Tips for Refinancing Your Mortgage
If you are considering refinancing your mortgage, here are a few tips:
Shop around for the best interest rate. Get quotes from multiple lenders before you decide on a refinance. If you don't want to do this, hire a mortgage broker who will do this for free.
Compare closing costs. The closing costs for a refinance can vary from lender to lender. Be sure to compare closing costs before you choose a lender.
Make sure you understand the terms of the loan. Before you sign any paperwork, be sure to read the terms of the loan carefully.
Do your research. There is a lot of information available about refinancing. Be sure to do your research so that you understand the process and make the best decision for your finances.
TL;DR
Refinancing in Canada is the process of replacing an existing mortgage with a new one.
There are many reasons to refinance in Canada, such as to get a lower interest rate, consolidate debt and obtain new mortgage terms.
The decision of whether or not to refinance in Canada should be made after considering the current interest rate, the length of time you plan to stay in your home, and your financial situation.
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