A home mortgage isn't like most other kinds of debt. The amounts of money involved are so large, and the loan lasts for so long, that a seemingly small adjustment in the terms of the loan can translate into huge savings. When you tinker with the terms of your home debt without actually changing the amount you owe, you call that a "straight refinance," and it can be a straight-up bonanza.
Refinancing is just a shorthand term for replacing one loan (or set of loans) with another loan (or set of loans), hopefully on terms more advantageous to the borrower. When you refinance your mortgage, you're taking out a brand-new mortgage on your home and using the money to pay off the existing debt.
Straight vs. Cash-Out
A home refinance typically falls into one of two categories: straight or cash-out. In a straight refinance, you come out of the process owing the same amount as before, but the terms of the loan are different. In most cases, people pull a straight refinance to get a better interest rate, which can save them tens of thousands of dollars in future payments. In a cash-out refinance, you come out owing more than before, because you convert some of your home equity to cash during the refinance. For example, say you owe $150,000 on a house worth $200,000, which means you have $50,000 in equity. In a cash-out refinance, you might take out a new loan for $160,000, of which $150,000 goes to pay off the original mortgage and $10,000 becomes cash in your pocket. That cash didn't drop from the sky, though. It came out of your home equity, which falls by $10,000 to $40,000.
The savings available from a straight refinance depend on how much you can lower your interest rate and how much time remains on your original mortgage. Say you originally took out a 30-year mortgage for $150,000 at 6 percent interest. Your monthly mortgage payment will be about $900. After five years, you'll still owe about $140,000, and over the remaining 25 years, you'll pay about $130,000 in interest on top of that remaining principal. Now say you did a straight refinance for the current $140,000 balance, but this time at 4.5 percent interest, and you do it over 25 years, to match the remaining term of your current mortgage. Your new monthly payment will be about $780, a savings of about $120 a month. Over the next 25 years, your total interest payments will be about $93,500 -- a savings of more than $35,000. What a difference 1.5 percentage points can make.
Though the interest savings is reason enough to do a straight "refi," you can find other compelling reasons to swap your old home debt for shiny new home debt. You might have an adjustable-rate mortgage, which has payments that rise and fall, and want the security of a fixed-rate loan. If you have more than one mortgage or a home-equity loan on top of your original loan, a straight refinance allows you to consolidate that home debt into a single loan. You may even do a straight refinance to address family issues -- to add a new spouse or partner to the mortgage or to take someone else's name off it.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.