How does refinancing a home loan work?

Refinancing a home loan is the process of switching from your current loan to a new one, either with the same provider or a new one. There are various reasons you might choose to do it. It could be that your fixed rate home loan is coming to an end and you’re looking to lock in another low fixed rate, or it could merely be that it’s time to switch to a better deal.

If you’re thinking about making the switch, you may be wondering – how does refinancing work, what do you need to do, and what steps go into it?

Refinancing a home loan: when should you do it?

What can you do to prepare for refinancing, and when do you know if refinancing is right for you? Several key indicators can suggest it may be time to review your loan:

1. The rate you’re paying. If your loan rate is higher than the rate your lender is offering new customers, or if you feel your repayments are too high, it could be time to look into refinancing. If you’re curious about the rates being offered to new customers, you can head to Canstar’s Home Loan Comparison Tool to get an idea of your lender’s latest rates, along with those of many other banks and lenders. It may help you see at a glance if your current rate is more expensive than what your lender might be offering others.
2. It’s been a few years since you reviewed your home loan. Seeing your home loan as a set-and-forget product can see you pay a higher rate than necessary. The mortgage market can change rapidly. If it’s been at least 2-3 years since you checked your home loan, it might mean that you’re not on the best deal available and it might be time to have a look around.
3. You want extra funds. Your home equity can be a valuable source of funds if you want to utilise it for a purpose such as undertaking renovations or purchasing a car. Refinancing can let you potentially pay a lower rate.
4. You’re coming off a fixed rate. If your fixed rate home loan is about to come to an end, it could be time to consider refinancing. When your fixed rate ends you will typically revert to a variable rate set by your lender, but this may not be the best rate available. Being proactive and searching for a more competitive rate that suits your needs could be worth doing.

How does refinance work?

The way refinancing a home loan works is quite straightforward. For most borrowers it can follow the 6-step process shown below:

1. Selecting your home loan. Choose the loan you wish to apply for, or ask your mortgage broker for recommendations. Along with a competitive rate, look for loan features that can help you save money on the loan such as a linked offset account.
2. Applying for the new loan. You’ll need to gather together pay slips, personal ID and bank statements to include as part of the home loan application process.
3. Loan approval. Once you have submitted a loan application, the bank may complete a valuation of your home. The outcome of the valuation matters because if you need to borrow 80% or more of your home’s current market value, you will be asked to pay lenders mortgage insurance (LMI). This applies even if you paid LMI when you first purchased the property. This is because LMI can’t normally be transferred between different banks.
4. Signing the loan documents. If your application is approved, the new lender will approve your home loan and send you or your mortgage broker a set of loan documents for you to sign.
5. Discharging your old loan. At this stage, your refinanced home loan is almost ready to go, and the new lender will get in touch with your old bank to confirm the value of the loan to be paid out.
6. Settlement of your new loan. With your old home loan paid out, the refinancing process is complete, and you can start making repayments on the new mortgage. In general, a refinance takes about a month (or longer, depending on the lender and the volume of applications they are processing). It can, though, be as quick as three weeks, especially if the homeowner has all the documents ready to submit with their application.

What happens to your equity when you refinance?

If you borrow the same amount with a new loan, your home equity is unchanged, and it will act as security on the new mortgage. If you want to get some cash out, you may need to take out a bigger home loan. The difference between the balance of your old loan and the value of the new loan represents the cash element, and can be used for whatever purpose you have in mind, or you can park it in an offset account if you don’t plan to use it immediately.

What happens when you refinance with the same bank or lender?

You may be wondering how refinancing works if you choose to stick with the same lender? If you choose to refinance to a different loan product with the same lender, this is a process known as refinancing internally.

You may wish to refinancing internally for a number of reasons. You may want to change from a variable rate to a fixed one, or from a fixed rate to a more attractive fixed rate. You may even wish to access the equity in your home while sticking with your current lender.

What are break costs?

When refinancing a home loan, you will need to end your current one. If you are on a fixed rate loan, then you may need to pay what’s called a break cost or a break fee to get out of it. Break fees are designed to compensate the financial institution for any loss of profit it faces as a result of a customer breaking the terms of the contract; including administration and its own wholesale borrowing costs. They do not typically apply to other types of loans, such as variable-rate loans.

Before breaking out of a fixed rate home loan, it’s important to understand exactly how much you might need to pay in break fees. Factor this into your decision-making if you’re only a short time into your loan as break fees are particularly expensive and could potentially cancel out the savings you stand to make by switching to a new home loan.

What should you watch out for when refinancing?

A home loan refinance may lower your repayments but it may not necessarily reduce the overall interest cost you pay. That’s because the default home loan term for most lenders is 30 years.

The federal government’s Moneysmart website notes that some lenders will only refinance with a new 25 or 30 year loan term. This could see you facing a longer term than the time remaining on your current loan And the longer you’re paying off a mortgage, the more you’re likely to pay in overall interest. Moneysmart suggests negotiating a loan term that’s similar to the time remaining on your current mortgage.

For older borrowers, the 30-year default loan term can mean the way refinancing works is slightly different. If you’re aged 55 or above, lenders will typically look for an exit strategy, such as downsizing your home, as a means to pay off the home loan when you retire.

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