Refinancing and loan assumption: What is the difference?
Characteristics of refinancing and loan assumptions
- Refinancing replaces one mortgage with another, entirely new loan.
- Rate-and-term and cash-out are the two main types of refinances.
- Refinancing does not preserve the original loan’s terms and rates.
- Loan assumption allows another party to take on the terms of an existing mortgage.
- Loan assumptions are generally cheaper than refinancing.
If you’re going through a major life change, like a divorce, and aren’t sure what to do with your existing home mortgage, a refinance or loan assumption are two options. The difference between the two, however, is a bit complicated and neither option may be perfect, depending on your situation.
Simply put, refinancing replaces one mortgage agreement with another, and loan assumption allows one borrower to remove another borrower’s name from the mortgage agreement, without changing other terms.
One possible drawback to refinancing is it effectively creates an entirely new loan, potentially with terms and interest rates that may not be as favorable as the current loan, especially if the borrower is refinancing because of a life-changing event, like a divorce, and cannot wait for interest rates to drop.
What is a rate-and-term refinance?
There are two basic types of refinancing: rate-and-term and cash-out. In a rate-and-term refinance, a borrower is looking for a lower interest rate and a lower payment. The term is the number of years for repaying the loan.
For example, a borrower may switch to lock in a lower fixed-rate interest and save money each month. Borrowers should look closely at the term, however. If they have already paid 10 years of an existing 30-year loan at 5.5 percent, switching to a new 30-year, 4.5-percent rate loan will actually cost them more money in the long run. By extending the life of the loan, the borrowers end up making interest payments for an extra 10 years.
Changing to a 20-year loan in this case would provide long-term savings. The monthly payments would be higher than getting a new 30-year loan, but the loan would be paid in a shorter period, and the total amount paid in interest over the life of the loan would be dramatically less.
What is a cash-out refinance?
Cash-out refinances allow borrowers to tap into the equity in their home. If a couple’s home is valued at $300,000, for example, and their loan balance is $200,000, these borrowers essentially own $100,000 of their home and can choose to convert a portion of that value into cash.
This is an appealing option in a divorce if one spouse is looking to buy out the other spouse’s equity share. Cash-out refinances also are often used to finance home improvements or to pay for large expenses, like college tuition.
The amount the borrower receives from the cash-out is added to the loan balance of the new loan, meaning the loan will take longer to pay off. Borrowers also must pay fees and closing costs on the new loan, which can cut into savings or increase the balance of the loan even more.
What is loan assumption?
If all you need to do is have a co-borrower removed from a mortgage because of a life-changing event, loan assumption may make more sense than refinancing. An assumption allows one party to retain the existing mortgage — with its current terms and rates — while removing the other party’s name from the loan.
One drawback is that the borrower who wishes to keep the home must be able to qualify individually for the loan. Lenders will look at credit scores, income, other debts and the home’s value before they sign off on an assumption. Lenders are often under no obligation to agree to a loan assumption, in which case, refinancing may be the only option. Be sure to compare lenders in this situation to identify the best rates and terms.
If the lender agrees to a loan assumption, the borrower keeping the home typically must provide a copy of the divorce decree and a quit-claim deed signed by the spouse who is giving up ownership. A quit-claim releases that party from any interest in the property. Loan assumptions normally include fees, but these are usually substantially lower than the cost of refinancing.