Introduction

With inflation stubbornly high and mortgage rates soaring, times are tough for many homeowners. Things can be even more challenging if you're looking to refinance your mortgage for a better deal, as there are few attractive options on the market.

If this sounds familiar, we’re here to help. In this article, we explore how mortgage refinancing works, the challenges of high rates, and options for overcoming these obstacles.

Understanding Mortgage Refinancing

Refinancing your mortgage allows you to replace the terms of your current home loan with a new agreement. Your lender then pays off any outstanding debt on your old loan. You can refinance with your current lender or switch to a new company.

Many borrowers confuse refinancing with a loan modification, but there are crucial differences. While refinancing your mortgage involves creating a new loan agreement, a loan modification alters the terms of an existing loan.

Likewise, most borrowers refinance to secure more favorable terms, whereas a loan modification is often a last resort for those struggling to repay their current loan.

Types of Mortgage Refinancing

There are 2 main options when refinancing your mortgage.

Rate-and-term refinancing

This allows you to replace your current mortgage with a new loan, including a different interest rate and loan duration.

Rate-and-term refinancing could be suitable if your credit score has improved since you took out your previous mortgage, or if you’d like to pay off your mortgage sooner than previously planned. You might also consider rate-and-term refinancing if you want to change the type of mortgage you have—for example, by switching from a fixed- to an adjustable-rate loan.

Cash-out refinancing

With cash-out refinancing, you can replace your current mortgage with another loan for a larger sum. The lender will pay you the difference between the old and new deals. You can use these funds for any purpose, including home renovation, your children’s education, or consolidating existing debts.

This type of borrowing typically carries lower interest rates than credit cards or personal loans. However, it increases the amount owing on your mortgage, and it may take longer to clear your debt.

The Mortgage Refinancing Process

When you’re refinancing, understanding each stage in the process can help you receive the best possible terms. Here’s a detailed explanation:

Assessing your current mortgage: Take a close look at your existing loan to make sure it meets your financial goals. For example, you may want to ensure that your current deal will allow you to be mortgage-free before you retire.

Also, consider whether your current interest rate will allow you to clear your debt as quickly as you’d like. If you’re paying a high rate, it likely means that a significant portion of your monthly repayments is lost to interest. As a result, it will take longer to pay off your principal debt.

Remember to factor in your mortgage term. Although a longer mortgage term results in lower monthly repayments, it will take you longer to build up equity in your property and to fully own your home.

Shopping for lenders: Try to compare as wide a range of lenders as possible. Although it’s tempting to focus on the headline interest rate, you should also consider factors such as fees and customer service. The simplest way to compare deals is to enter your details into a price comparison site, which can search the market within seconds.

Applying for refinancing: Depending on the lender, you can make your application online, over the phone, or in person. As part of the process, potential lenders will provide you with a loan estimate containing your projected interest rate, monthly repayment, and total cost.

Providing your documentation: Once you’ve chosen a lender, you’ll need to provide documents for yourself and any co-borrowers. These may include government-issued IDs, pay stubs, W-2s, current mortgage statements, and a home appraisal.

Closing on the refinanced loan: During the final stages of your application, your lender will provide you with a closing disclosure including your loan terms and closing costs such as the origination or attorney fee. The lender will also take steps to confirm the details you provided in your application and conduct a title search and home inspection. Closing typically takes 30-45 days.

Refinancing in a High Interest Rate Environment

Most lenders link their mortgage interest rates to the federal funds rate, which is the rate banks charge each other for overnight lending. During times of high inflation, such as we’re currently experiencing, the US Federal Reserve typically increases the federal funds rate.

Unsurprisingly, this has had a knock-on effect on mortgages. According to Morningstar, the average 30-year mortgage rate for July 2024 stands at roughly 6.9%. This is higher than the 3% average of 2021 and the pre-COVID-19 average of 4.2% in 2017 to 2019.

What to consider when rates are high

Inevitably, this environment brings challenges for homeowners wishing to refinance. Most obviously, it can be more difficult to secure a lower rate than in previous years. With fewer attractive deals on the market, lenders also tend to reserve their best offers for borrowers with the highest credit scores.

The uncertainty of a high-rate environment can also make some people feel less secure in their jobs, which could make it an unsuitable time to refinance.

Strategies for mitigating the impact of high interest rates

Despite the challenges, there are steps you can take to secure a competitive deal:

Improve your credit profile: As most lenders reserve their best rates for those with good or excellent credit, maintaining a strong score is crucial. You can do this by making payments on time, avoiding new credit applications, and regularly checking your file for errors.

Timing major life changes: Lenders like to see evidence of stability. You might therefore want to postpone your application if you’ve recently changed jobs or made another significant life move.

Checking the fine print carefully: As every penny counts in a high interest rate environment, it’s wise to check your agreement for hidden charges, such as costly exit fees.

Consider the loan term: Also remember that interest rates will likely come down again in the future. If you opt for a lengthy fixed-rate mortgage during a high-rate environment, you can find yourself tied to a deal that becomes uncompetitive if the economy rallies.

Key Factors to Consider When Refinancing

When you’re refinancing your home, there are several things you should be aware of.

Interest rates: Comparing rates to your existing mortgage is the most obvious place to start during a refinance, but understanding different loan types is also key.

A fixed-rate mortgage guarantees you repay the same amount every month over a set period. With an adjustable-rate mortgage, your loan will begin with a fixed interest rate for a set period and then change according to circumstances within the wider economy.

Loan terms: Mortgage loan terms are typically 15, 20, or 30 years. Longer mortgage terms usually carry lower monthly repayments. However, repaying your mortgage over more years can increase the amount of interest you pay over the lifetime of your debt.

Closing costs: Closing costs are expenses you’ll need to pay to finalize your loan. Examples include origination fees for mortgage processing, appraisal fees, attorney fees, and home inspection charges. Closing costs are typically between 2% and 5% of the value of your loan.

Home equity: Most lenders require you to have at least 20% equity before you can refinance your mortgage. To calculate your home equity, first determine its current market value through a home appraisal or by using an online calculator. Then, subtract the current amount owing on your mortgage. The remaining figure is your equity.

Benefits of Refinancing

Whatever the interest rate environment, refinancing a mortgage usually offers benefits. Let’s take a look at some of them.

A better loan rate: Securing a lower rate can reduce your monthly repayments and decrease the total cost of borrowing over the lifetime of your mortgage.

Paying off your mortgage more quickly: Switching to a loan with a shorter term can help you become mortgage-free earlier in life. Although this may result in higher monthly repayments, it can also cut the amount of interest paid over the lifetime of your mortgage.

Tapping into existing equity: If you’re looking to finance a new venture or have unforeseen expenses, a cash-out remortgage could help you access the money in your property.

Risks and Drawbacks of Refinancing

While refinancing can have significant advantages, there are also potential downsides. Some of the most common ones include:

Higher long-term costs: If you extend your mortgage term to secure lower monthly repayments, you may end up paying more interest over the lifetime of your mortgage, so you should factor this into your financial planning.

An adverse effect on your credit score: When you apply for a new deal, a lender will perform a hard search on your file, which will cause your credit score to drop. Additionally, withdrawing from your old deal can hurt your score, as the age of your accounts is a factor in determining your creditworthiness.

Common Pitfalls to Avoid

Here are some mistakes to avoid if you want the refinancing process to run smoothly:

Refinancing when it doesn’t make sense: Refinancing could be a costly mistake if there are high exit fees on your current mortgage or if a recent change in your circumstances has led to a drop in your credit score.

Overlooking closing costs: Pay close attention to any fees associated with finalizing your deal. This way, you can make sure the savings resulting from a lower interest rate would offset the cost of refinancing.

Failing to shop around: Although comparing a range of providers can be time-consuming, it can save you thousands of dollars over the long term.

Conclusion

With high inflation and interest rates creating uncertainty in financial markets—and attractive refinancing deals being few and far between—homeowners face numerous challenges.

While refinancing a mortgage can help you secure a more competitive rate or tap into your home equity, it may be a mistake if you face high closing costs or if the application adversely affects your credit score right before you apply for another loan.

Whatever the interest rate environment, research is key to securing a good deal when refinancing a mortgage. Comparing a wide range of lenders and carefully reviewing the terms can ensure you have access to the most competitive rates and can make an informed choice.

While the environment is undeniably tricky, searching for the best deal through a price comparison service can be a great way to compare a range of products and find the loan that meets your needs.