What is Refinancing a Mortgage?
A mortgage refinance involves breaking your existing mortgage contract and replacing it with a new one.
The purpose of refinancing is to alter certain aspects of your mortgage, such as the interest rate, term length, or to tap into your home equity to borrow money.
While you may have been content with your initial mortgage, personal and financial circumstances (and economic conditions) can change, sometimes abruptly.
As a result, your mortgage’s structure and features may no longer align with your goals, lifestyle, and budget.
In such scenarios, refinancing may be the optimal solution to getting the most suitable mortgage for you.
When to Refinance a Mortgage
There are several instances where refinancing your mortgage is a wise move.
Here are the most common:
1. Interest Rates Have Gone Down
No homeowner wants to get stuck with a steep interest rate on their mortgage.
High rates result in larger monthly payments and substantially increase the total cost of the mortgage over time.
For this reason, many choose to break their mortgage contract when average lending rates across the country begin to plummet.
By doing so, they can secure a new, considerably lower rate and realize significant savings in interest payments.
While the prepayment penalty to break your mortgage needs to be factored in, depending on your contract, remaining term and the new interest rate, in many scenarios refinancing for a lower rate can make complete sense.
2. You Want to Access Your Home Equity
Another popular reason for refinancing is to access your home equity (the difference between your home’s value and your current mortgage balance).
This arrangement entails paying out your existing mortgage and arranging for a new, larger mortgage, while receiving the difference in cash.
You can use the lump sum of money to pay for a significant expenditure like a wedding or home renovation or add to your investment portfolio.
In Canada, you can borrow up to 80% of your home’s equity by refinancing, less your mortgage balance and any other debt secured by the property.
For example, suppose your property’s appraised value is $450,000, and your outstanding mortgage principal is $210,000.
In this case, the maximum you can refinance for is $360,000 ($450,000 x 80%).
After subtracting your balance owing, you have $150,000 available as cash ($360,000 – $210,000) to spend as needed.
You’ll be responsible for contributing timely payments on your new $360,000 mortgage balance.
3. You Want a Different Amortization Period
The amortization period refers to the time required to pay off your entire mortgage through regular payments.
Amortization schedules range between 15 and 35 years in Canada, with 25 years being the most common.
Renegotiating your mortgage contract will allow you to choose an amortization schedule better suited for your financial goals and budget.
You can dramatically impact your monthly payment size and the time needed to pay off your mortgage by shortening or lengthening this period.
How Does a Mortgage Refinance Work?
To kickstart the refinancing process, contact the financial institution that holds your mortgage and ask to speak to a mortgage specialist.
First off, the advisor will calculate your loan-to-value ratio (LTV) to see if you qualify for a refinance.
Before considering your application, most lending institutions prefer that your LTV be no higher than 80%.
If you meet the LTV requirement, they’ll explain what kind of refinancing options are available to you.
They’ll work with you to tailor your new mortgage with the ideal principal size, interest rate, amortization period, and other relevant attributes.
Since refinancing involves acquiring a brand-new loan, you’ll need to satisfy the eligibility criteria like you did when you applied for your initial mortgage.
In this step, your lender will perform a hard inquiry into your credit report, verify your income and assess your debt service ratios.
You’ll also need to pass the mortgage stress test again.
The current value of your property is a crucial component of refinancing, especially if you’re looking to borrow money against your home equity.
As a result, your lender will hire a professional to appraise its fair market value.
The mortgage specialist will also inform you of the total cost of fees you must pay, including the prepayment penalty, if applicable.
Once everything is complete, your lender will prepare the necessary documentation that outlines your mortgage’s terms and conditions and will be used to close the deal.
Ensure you take your time scrutinizing the details for any errors or omissions before signing your these documents.
Once the loan is closed, your lawyer will help with receiving the new mortgage funds, paying out and discharging the existing mortgage and getting things like title insurance in order.
They’ll also provide a bank draft or direct deposit any amount owed to you if you’re borrowing against your home equity.
At this point, you assume responsibility for making payments on your new mortgage.
You can expect the refinancing process to take a few weeks.
When refinancing your mortgage, you should contact different lenders to see if they can offer you a better deal than your current lender.
Benefits of Refinancing a Mortgage
Here are the primary advantages associated with mortgage refinancing.
1. Great Way to Save Money
If your current mortgage interest rate is substantially higher than what the market presently offers, refinancing will enable you to lock in a more competitive rate and save money on interest costs.
As less interest accumulates on your principal, your monthly payments will also decrease.
2. Get Access to Cash at a Low Rate
Refinancing allows you to merge your high-interest debt or finance an expensive project like a home renovation at a cheap rate.
This is accomplished through a cash-out refinance, where you borrow money against your home’s equity.
Since your property secures the mortgage, you can gain access to much lower rates than if you opted to use a credit card or unsecured line of credit.
3. Optimize Your Payment Schedule
When you refinance, you can select a different amortization schedule that better accommodates your cash flow, budget, and financial goals.
If your current mortgage payments are straining your finances, by extending your amortization period, your monthly payment size will decrease, providing you with some financial relief.
If you wish to pay off your mortgage sooner than you originally anticipated, you can shorten your amortization period, which will increase your monthly payment.
This allows you to pay down your principal at a quicker pace and save on interest costs.
Risks When Refinancing a Mortgage
Before calling your bank to initiate a refinancing deal, ensure you know the risks involved.
1. Potential Debt Problems
Your new mortgage may consume a considerable chunk of your budget and leave little room for other expenses, taking a financial toll on your household.
If you’re already heavily in debt, you can struggle to keep up with your larger payments.
In the worst case, your lender can foreclose on your home or you may have to file for bankruptcy.
2. No Guarantee of Cost Savings
While refinancing can seem like an appealing method to lock in a low-interest rate, there’s no reliable way to predict the direction of the broader financial markets.
If your hunch about interest rates is incorrect, you can lose money rather than save it.
3. Penalties and Fees
If you hold a closed mortgage and decide to refinance before your term’s expiry date, your lender will charge you a prepayment penalty.
Many borrowers are often surprised by how steep this fee can be.
In some cases, it’s high enough to offset all or most of the financial benefits associated with refinancing.
In addition, refinancing your mortgage usually entails paying various other fees, which include:
- Legal fees
- Home appraisal fees
- Mortgage registration
- Mortgage discharge fee (if you’re refinancing with a new lender)
Did You Know
Most mortgage lenders provide handy calculators that allow you to estimate the cost of your prepayment penalty, such as this one by BMO.
Frequently Asked Questions
- What does it mean when you refinance your house?
Refinancing your home involves replacing your current mortgage contract with a new one. To do so, you need to requalify under your lender’s criteria.
The refinancing process doesn’t necessitate selling your house. Instead, the purpose is to gain access to home equity or secure a more favourable rate and better terms.
- What is the difference between refinancing and mortgage?
A mortgage is a long-term debt product borrowers use to finance a home purchase.
Refinancing enables you to renegotiate a new mortgage contract. Once you secure financing for your new mortgage, your lender uses the funds to pay off your old mortgage balance. You then resume making payments under the new one.
You can apply for a mortgage without refinancing, but refinancing always entails acquiring a mortgage.
- Is refinancing ever a good idea?
Refinancing your mortgage is a financially savvy way to save money and enhance your financial standing. However, only under the right circumstances.
You should explore the possibility of refinancing if you can lower the overall cost of your mortgage or negotiate terms and features that will benefit you in some way. Also, you’ll need to calculate the prepayment penalty and other fees involved to ensure refinancing is worthwhile.
If the math works in your favour, you’ll net savings on interest costs, lower your monthly payments, and have the opportunity to access your home equity at a low rate.