How does a refinance work?
When you refinance your home loan what you are doing is opening a new loan and using those funds to pay off your current loan. There are many reasons to refinance your home besides a lower rate. I will go through those in a later post. For now I just want to go over how a refinance works.
I am a local mortgage broker serving Omaha, Papillion, La Vista, Bellevue, and all of eastern Nebraska. If you think you could benefit from a refinance or are just curious about refinance options, I can help.
- Determining your current loan balance
- Determining your current home value
- How does escrow work on a refinance – Read this one!
- “Skipping a payment”
- Pinning down exact numbers on a refinance
Determining your current loan balance
There are several numbers we need to figure out before determining if a refinance is a good idea. Obviously we need to know the amount you currently owe on your mortgage. This may seem easy (just look at your last statement) but there are a few things to consider.
Per diem interest
The balance on your mortgage statement and the actual final pay off are going to be different. Your mortgage statement will show the current balance on your loan, but remember that interest on a loan is always accruing. Also, your mortgage payment is always paying the interest for the previous month.
For example, let’s say you make your February payment on the 1st. That payment is paying all the interest that built up in the month of January. Starting February 1st you are accruing daily interest that will be paid with your March mortgage payment. Now if we are refinancing your current loan and closing say February 24th you will have to pay at close the balance of your loan plus accrued interest from February 1st through the 24th. So in almost all cases on a refinance the actual pay off is going to be higher than the balance showing on your statement.
Will another payment be made before close?
A refinance, just like a purchase, can take 30 days or longer to close. We have to collect documents, wait for an appraisal, clear conditions, and schedule a closing. It is likely that between the time we start the loan and when we close you will have to make another payment on your current mortgage. So the balance on your current loan will be different when we close from when we started. Depending on when you come in and how busy everyone is on refinances (during a “refinance boom” everyone is trying to refi and all parts of the process slow down) you may make two payments between the start and close of your loan.
We will wait to order your final pay off until we know when you will close and all payments have been made. We want to make sure we have the most accurate pay off and that your last payment is reflected on the numbers…You don’t want to double pay on your current mortgage.
Determining your homes value
This is another tricky part. A big reason people see advantages in refinance is because the value of their home has gone up since they bought it. Usually the more equity you have in your home the more benefits you get out of refinancing. But until we have an appraisal that gives us the official value, we have to take educated guesses.
There are ways to estimate value. The first is with an automated valuation. This is an instant valuation based on average sales in the area. It is a free and quick way to at least get started. In a city, like Omaha, with more houses and more data, it can also be pretty accurate assuming you have not done any major remodels. Down below is a free valuation tool you can use on your own.
Comparative Market Analysis
A more accurate way to estimate value is with a CMA. Your realtor can do a write up of what they think the house would likely sell for if it were put on the market. This is more accurate than an automated valuation because it is looking at your individual house and not just neighborhood data. If you did any improvements or renovations they will be reflected in the CMA. If you did not have an agent when you purchased your home or are no longer in contact with your agent, we can connect you with a realtor who will be happy to provide this service free of charge.
How does escrow work on a refinance?
Escrow is the one thing that confuses everyone on a refinance. It is confusing on a purchase and on a refinance it has even more “moving parts”.
What is escrow?
So if you are like most homeowners, your taxes and insurance are paid through your mortgage. Every month a portion of your payment goes into an account and, when they are due, the mortgage company uses those funds to pay your insurance and taxes. Most of us probably don’t even think about it after we start making the payment. But that escrow account fluctuates. It builds a balance (which could be several thousand dollars) and then depletes when an item is paid. If you log into your current mortgage account you can find a spot that tells you the current balance and has a schedule of when your taxes and insurance funds were dispersed.
Escrow accounts do not transfer
Here is the difficult part. That current escrow account is part of your current mortgage. It is your money in that account not the mortgage companies, but it is a part of your current mortgage and cannot be transferred. This creates confusion on a refinance.
A new escrow account
A refinance is the opening of a brand new mortgage. It can be with the same company or with a completely different mortgage company (you are not obligated to use your current lender on a refinance). When we pay off your current mortgage we cannot just transfer that escrow account to the new loan. That escrow account must be closed and a new one has to be started on the new loan. That new escrow account has to be filled with enough funds to pay any upcoming taxes or insurance. So in addition to any cost on a loan, you must also contribute money to this new escrow account. If taxes and insurance are coming due in the near future, you could be putting several thousand dollars into this new escrow account at close.
What happens to the old escrow account?
Funding that new escrow account can be a shock to a lot of people looking to refinance. I first want to say that we do have options to roll that into the new loan so you are not bring that cash to the closing. But what about your old escrow account?
Like I said earlier, that money in that escrow account is yours, not the mortgage companies. When your current loan is closed out the current lender has to send that money back to you. Now this can take 3 to 4 weeks after we close, which I know can be frustrating. If your current escrow account was large you would have to set up a large escrow account with the new loan and now you have to wait weeks to get the money back on your current loan. And for us millennials, or whatever the generation is called right before millennials, wait for a huge check to come through the Post Office can feel a bit insane. I am in my 40s and I still think it is crazy to just put stuff in an unlocked box outside your house.
Contact me for more details
This escrow thing does require a bit of personal explanation and will require a lot of math to calculate exactly how much you will need on the new account and how much you will get back on the current account. If you want to discuss this in more detail please contact me.
Skipping a payment
You will here this a lot as a selling point on a refinance. You will skip one payment on the refinance. Technically this is true, but I should point out you are not getting a free month of interest on the loan. The skipped month is necessary on a refinance so the new loan can get on track with accrued interest.
How you “skip a payment”
So let’s say you close February 24th. You will pay the daily interest on your current mortgage through the pay off just like I mentioned above. On the new loan you will pre-pay interest on the new loan for the rest of February. So in addition to closing cost and the new escrow account, you will pay daily interest on the new loan from February 24th to the 28th.
So on this new loan you have pre-paid interest to March 1st. On March 1st your interest starts accruing on the new loan and on April 1st you will pay all the interest from March 1st through the 31st. Remember interest is always paid “in arrears” so your mortgage payment is always paying the previous month’s accrued interest.
So you did technically skip a payment. You made your February payment on your current loan and the new loan payment is not due until April. The interest that would have been paid with the March payment was included in the pay off of your current loan and the cost of closing your new loan. It is an option to increase the loan amount (assuming the equity is there to do so) and cover all cost, new escrow, and pre-paid interest in your new loan amount. You could bring no money to close, skip that March payment, and get all the money back in your current escrow account back right around the time of your first payment on the new loan.
Pinning down exact figures on your refinance
Just like on a purchase, there are a few unknowns at the start of a refinance. We may not have the exact amount of your final pay off. At the time we start it can be difficult to pin down exactly what will be put in the new escrow account and what you will get back from your current escrow account. Just like on a purchase, some of the third party fees (mostly title) start off as estimates.
Honestly, on a refinance there are a few more unknowns at the start than there are on a purchase. An appraisal that comes in lower than expected can change the terms of a loan. We might not have an exact closing date at the start of a refinance. The escrow is a bit more difficult to get exact in the beginning.
It is important to go over all of this with your loan officer at the beginning so you can plan for any changes that might affect the terms or the cash needed at close. It might also be a good idea to put together some contingency plans if we get a more conservative home value on the appraisal.
Bonus: How will I know if a refi is a good idea?
There are many reasons to refinance. Obviously you might want to lower your payment or get a lower rate. But you could also look at taking some of the equity out of your home for debt consolidation or home improvements. Or perhaps you have an FHA loan and would like to switch to conventional to drop the Mortgage Insurance.
Probably the most important thing to consider on a refinance is how long you plan on staying in the house. The benefits of a refinance are based on how long you plan to enjoy that lower payment or rate. If you think you might move in the near future, it might not be worth doing even if you can lower your payment.
Because all mortgages have cost, and because most of those cost are fixed, the biggest benefit to refinancing usually comes with higher loan amounts. A much lower rate on a small loan might not change the monthly payment that much. I can help you do a fully review of all options before moving forward with any home refinance.
Other useful links
- How to improve your credit
- The 20% down rule on conventional
- What is Escrow?
- How is income calculated?
- Why your assets matter
- Mortgage Calculator
- Is Credit Karma accurate?
- FHA vs Conventional, which is better?
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