How does refinancing a home loan work?

How does refinancing work?

Refinancing a home loan is quite straightforward. For most borrowers it can follow the six-step process below:

1. Selecting your home loan: Choose the loan you wish to apply for, or ask your mortgage broker for their recommendations. Along with a competitive interest rate, look for loan features that can help you save money such as a linked offset account or redraw facility.
2. Applying for the new loan: You’ll need to gather relevant information for your application, such as your pay slips, bank statements and photo ID.
3. Loan approval: Once you’ve submitted your application, the lender 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’ll generally 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 lenders.
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 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 one 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’re processing). It can, though, be as quick as three weeks, especially if you have all the documents ready to submit with your application.

What is refinancing?

Refinancing a home loan is the process of switching from one home loan to another, either with the same or a different lender. Once your application has been approved, your chosen lender will pay out your old loan and set up your new one.

When should you consider refinancing a home loan?

• Your loan’s interest rate isn’t competitive: If your rate is higher than the rates 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 use Canstar’s Home Loan Comparison Tool to get an idea of your lender’s latest rates, along with those of many other lenders. It can be helpful to see at a glance if your current rate is still competitive—or if it may be time to consider switching.

• You want to fix your home loan rate: If interest rates are low or you want to avoid the potential increases to your variable rate that come with increasing interest rates, it may be worth fixing your home loan. If you find a fixed-rate home loan from a different lender is offering you better value, it may be time to refinance.

• It’s been a few years since you reviewed your home loan: Treating your home loan as a set-and-forget product may lead to you paying a higher rate than necessary. The home lending market can change rapidly, especially if the cash rate is increasing or decreasing. If it’s been at least two to three years since you last checked your home loan, it might mean that you’re not on the best deal available anymore.

• You want access to extra funds: The equity you have in your home (i.e. the amount you’ve paid towards the original amount you borrowed, not including interest) may be used to increase your loan size or open a line of credit, which can allow you to borrow additional money. These extra funds may be used to renovate your home or purchase a car.

• You’re coming off a fixed rate: When your fixed-rate period ends you’ll typically revert to the variable rate set by your lender, but this may not be competitive when compared to other variable-rate loans on the market. Being proactive and searching for a more competitive rate when your fixed-rate period is coming to an end is often worth doing.

• You want additional loan features: You may not have been offered certain features when you initially applied for your home loan and now wish to utilise them. Offset accounts and redraw facilities may help you pay less in interest and therefore pay off your loan faster.

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Fees, rebates and cashback offers: what to watch for

When refinancing, it’s important to look beyond the headline rate. Fees and incentives can affect the true cost of switching, and in some cases, a lower rate with higher fees may not work out cheaper overall.
Common refinancing costs include:

• Application or establishment fees: Charged by some lenders when you take out a new loan.

• Property valuation fees: Often covered by the lender, but not always.

• Discharge fees: Charged by your existing lender when closing your current loan.

• Monthly or annual package fees: These can add up over time and should be included in your cost comparison.

Make sure you calculate the full cost of switching, including fees on both the old and new loan.

Cashback offers

Many lenders offer cashback payments, sometimes several thousand dollars, to encourage borrowers to switch. These can be appealing, especially when upfront costs are a barrier. It’s worth bearing in mind, however:

• Cashbacks usually come with strict eligibility criteria, such as minimum loan size or LVR requirements.

• They don’t necessarily mean the loan is better value in the long run. A competitive rate and lower fees generally deliver more meaningful savings over the life of the loan.

• Some lenders have tightened or withdrawn cashback promotions in favour of lower ongoing rates, so it’s important to compare both the incentive and the long-term cost.

Rebates and fee waivers

Some lenders may offer limited-time fee waivers on valuation or settlement costs. These can reduce your upfront expense but, like cashback offers, should be considered alongside the interest rate and features available.
A cashback or rebate can be a helpful sweetener, but it shouldn’t be the deciding factor. Compare the full cost of the loan—interest rate, fees, features and long-term savings—to make sure refinancing truly works in your favour.

What happens to your equity when you refinance?

If you borrow the same amount with your new loan, your home equity is unchanged, and will act as security on the new mortgage. If you want to access additional funds, 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 one represents these funds, and can be used for whatever purpose you have in mind, or you can leave them in an offset account if you don’t plan to use them immediately.

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

If you choose to refinance to a different loan product with the same lender, this is known as refinancing internally. You may wish to refinance internally for a number of reasons, such as wanting 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 you’ve built up in your home while sticking with your current lender.

What are break costs?

When refinancing a home loan, you’ll need to end your current one. If you’re 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 don’t 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?

Refinancing your home loan 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.