What is Refinancing and How Does it Work?
Let's say that you received your mortgage at a higher interest rate a few years ago, and now you hear that someone has refinanced it, saving money. It sounds fascinating, doesn't it?
Refinancing is a smart move to lower payments. Tap into a home equity loan, or maybe switch to better loan terms.
However, is it good for you? That is the main question you need to consider. Don't worry this blog will explain everything to you, including what refinancing is, how it works in Canada, and whether it will help you with your financial matters.
What is Refinancing?
Refinancing is the process of revising and replacing/updating an existing loan with a new loan arrangement. It is typically done to improve the loan period or lower your interest rates. If it gets approved, the borrower's current loan is replaced with the new one.
Refinancing involves:
- Utilizing the equity you have accrued in your home to release funds. This money might be used for several things, such as a car, home renovations, college or university tuition, or even starting a new business.
- Also, you can refinance to pay off expensive debt, like credit card debt, using your built-up equity.
When interest rates decrease, borrowers who refinance can save a significant amount of money on the loan's total cost. Refinance comes in a variety of forms, each with advantages and disadvantages.
Types of Refinancing:
Mortgage Refinance:
A mortgage refinance is terminating your current mortgage agreement and using a new loan to pay off the amount in full. This new mortgage carries its own set of terms, conditions, and interest rates.
Refinancing might help you get a lower mortgage rate or convert home equity into cash. It actually pays to study as much as you can about refinancing a home loan before starting the process with your lender.
Rate-and-Term Refinancing
Rate and term refinancing is the most common one. This refinancing involves when the previous loan is paid and replaced with the new loan at a lower interest rate, with a new loan agreement.
Cash-out Refinancing
With a cash-out refinance, you can take out a new mortgage for more than what you now owe because your house value has increased.
It lets you borrow more money than you actually owe now, using the equity in your house.
Often results in a higher loan balance and a higher interest rate. This way, the borrower retains ownership of the asset, because this will increase the total loan amount and give access to the cash immediately.
Cash-in Refinancing
A cash-in refinance lets the borrower make smaller loan payments or reduce the loan-to-value (LTV) ratio by paying down a portion of the loan.
Consolidation Refinancing
When an investor receives a single loan at a rate lower than their current average interest rate across many credit products, they can opt for consolidation refinancing, it is the best option.
In order to refinance, you must first apply for a new loan at a lower interest rate and then use the new loan to pay down your current debt.
It also helps you leave your outstanding debt at a lower interest rate.
What does it mean to refinance your home loan?
Refinancing your home loan is replacing your existing loan with a new one that works better for your financial situation.
There are two common types of refinancing:
- External refinance: You switch to a new lender or a new home loan maybe, to access assets, to get lower interest rates, and to reduce payments.
- Internal refinance: You don’t switch to a new lender, you simply just make some changes to your loan. Typically, in this case, you extend your loan term and revise the interest rate (from fixed to variable and vice versa). You can switch to interset-only repayments if you need to.
How does refinancing work?
One of the most important reasons to refinance for any borrower is to improve the loan’s interest rate.
It's identical to the process you went through to get your initial mortgage loan to refinance a mortgage.
Here are the steps you need to follow:
1. Assess Your Situation
2. Shop Around
3. Run the Numbers
4. Submit Your Application
5. Close Your Loan
1. Assess Your Situation
The criteria for refinancing and new mortgage loans are the same.
Lenders will evaluate history including your:
- Credit score and history
- Current loan history
- Income and work history
- Home equity
- Current value of the home
You'll review where you stand in these areas to check if you’re qualified for this.
- If you have a good credit score and history, a lot of equity in your home, and a stable income, you can be eligible for better terms on a new loan.
- If your credit score has decreased since you took your first mortgage or you have more debt overall, you might not get approved for more favorable terms.
2. Shop Around
Compare interest rates and other parameters, and go through the preapproval procedure with several mortgage lenders. This will increase the chance that you will get the best deal available, at favorable terms.
You should not only compare refinance offers with one another but also compare the terms of your existing mortgage loan. This will help you decide if refinancing is good for you or not.
3. Calculate the Numbers
Once you decide what’s the best deal for you, compare possible costs and savings.
Refinancing might not be the best option if you don't intend to remain in the house for very long.
Also, if you refinance or pay off your current mortgage early, be aware of possible problems such as prepayment penalties.
4. Submit Your Application
You are now prepared to apply directly to the lender of your preference. You must submit some details about yourself, your home, and your current mortgage loan.
To complete the application, you will also need to submit relevant documents.
These documents include:
- Income proof: T4 slips, recent pay stubs, or a Notice of Assessment (NOA) from the CRA.
- Bank statements: 3-6 months of financial stability.
- Tax returns: 2 most recent tax returns.
- Government-issued ID: such as a passport or driver's license.
- Property documents: Home insurance, property tax bills, and mortgage statements
Refinancing a mortgage in Canada usually takes two to four weeks to close.
Depending on the lender's criteria, the need for extra paperwork, and the length of time needed for property appraisals, this timeline may change.
5. Close Your Loan
When the lender is ready to close the deal, you’ll come and sign papers to make everything official. The lender will then create an account for your new loan and pay off your previous one.
In terms of cash-out refinances, you’ll receive cash via cheque or wire transfer maybe.
What does refinancing actually do?
When you refinance, your existing mortgage is replaced with a new one, usually with a different interest rate. With the new mortgage loan, the lender repays the previous one, typically giving you better terms and a lower interest rate.
Does refinancing affect your credit?
When you refinance your mortgage a credit check is performed. Refinancing will lower your credit score. This is only temporary, though, and your score will change over time. Since you will have less debt and a lower monthly mortgage payment after refinancing, and may improve your credit score.
How do I qualify for refinancing?
In Canada, you have to meet the same standards as your initial mortgage to be eligible for a refinance.
- First, assess your existing loan balance, interest rates, and savings.
- You must consider prepayment penalties, registration fees, and other legal expenses.
- Calculate the numbers to assess, if refinancing is beneficial for your financial situation.
- Lenders will evaluate your credit score, history, and financial stability.
- Some may require documents typically including pay stubs, tax returns, bank statements, mortgage details, and property value.
- To get the best terms and rates, compare several lenders.
Which loans can be refinanced?
In Canada, various loans can be refinanced.
Mortgage refinancing: homeowners can access up to 90% of the value of their house through mortgage refinances for building secondary assets.
Business loans can also be refinanced. Lenders share the risk with small businesses through initiatives like the Canada Small Business Financing Program.
Personal loans, student loans, and auto loans can also be refinanced.
Refinancing isn’t free, there are costs you need to consider. There may be fees such as prepayment penalties and other legal expenses.
Final Things To Think About
As you are considering applying for refinance, it is critical to understand where you stand with your credit.
First asses your credit score as you don’t want any surprises.
If possible avoid getting new credit before and during the process as this can impact your credit history and score and maybe you won’t get approved at the end.
If your credit history is good, you’re already eligible for refinancing, no need to worry about that.
Imagine that just when you are about to move into your ideal home, a minor credit problem throws everything off.
Thus, the secret is to be prepared. A little effort can save you time and money in the long term.
Disclaimer: This content is based on current facts and intended purely for informational purposes. Always ask your lender about current details.