What Happens to the Principle When You Refinance?

Learn about refinancing.
Learn about refinancing. (Image: $100 house image by Paul Heasman from Fotolia.com)

The refinancing process is intended to provide the homeowner with a lower interest rate. In turn, the reduced interest rate lowers the monthly mortgage payments. The principal, however, remains unchanged during the refinancing process. After all, the money paid into principal is essentially the money paid toward the actual purchase price of the home. When homeowners refinance, they are still obligated to continue paying on what remains of that purchase price. It is, in theory at least, only the payments toward interest that change.

Refinance Process

When a homeowner refinances his or her home, the bank creates a new loan package, using the collateral of the home to pay off the first loan and then creating a new loan with a reduced interest rate. Because the interest rate is lower, the monthly payment is lower and often by several hundred dollars. This reduced payment, though, reflects only the part of the payment that was going toward interest. The part of the payment that was going toward principal, or the actual purchase price of the home, remains the same.

Closing Costs

Except in very rare cases, the refinancing process involves closing costs. In some cases, the lender requires the closing costs to be paid up front. In other cases, though, the homeowner can request that the closing costs be applied to the loan. If the homeowner opts to apply closing costs to the loan, these costs may be added to the principal of the loan. When this occurs, the principal obviously increases in the new loan.

Extra Fees

Extra fees during the refinancing process can sometimes increase the principal of the new loan. These fees include such items as leftover interest from the old loan (which is added to the principal of the new loan) and penalties for paying off the loan early. Bear in mind that when you refinance you essentially pay off the old loan using the home as the collateral, so your lender can charge you a prepayment penalty if this was stated in the old loan. Other fees that can increase principal also include payoff charges for paying off the old loan (separate from prepayment penalties) and the fees required to release the old lien on the property in order to complete the refinancing process.

Refinancing Benefits

Despite the extra fees that might be added to the principal of the loan, refinancing still offers some benefits. Even with the increase in the new note, the homeowner has reduced monthly payments, thus freeing up extra cash. Additionally, refinancing can be a great way for homeowners whose property value has increased. Some refinancing packages allow homeowners to take out equity on their home during the refinancing process: because the principal has not changed but the value of the home has, the homeowner can utilize the value of the home by cashing out on it.

Expert Insight

Some real estate experts caution homeowners against refinancing, because it does increase the life of a loan and can leave the homeowner making unnecessary payments. A homeowner who bought a home with a 30-year mortgage in 2000 and decided to refinance with another 30-year mortgage in 2010 ultimately has a 40-year mortgage. And while the original principal does not change, the added fees can increase the principal on the new mortgage, meaning that the homeowner is also paying interest on these fees over time.

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