If you’re curious about whether you can save some money by refinancing your mortgage loan, but aren’t quite sure where to start, we have you covered. Currently, according to the Mortgage Bankers Association, mortgage refinances make up a substantial portion of all mortgage loan applications. This may be largely because mortgage rates have enjoyed historic lows for the last few years.
Refinancing a mortgage can be complicated and intimidating. However, if you do your due diligence and take your time, you can make a sound choice about whether refinancing is a good option for you. From your credit score to what kinds of fees to expect, we’ve outlined everything you need to know to make sure refinancing is in your best interests. Overall, refinancing your home can be a smart way to save money and protect the equity in your home dramatically. If you think you might be ready to refinance, keep reading to learn more.
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What is a Home Mortgage Refinance?
When you bought your home, you likely took out a mortgage, and you’ve been paying monthly payments toward that loan ever since. When you choose to refinance your home mortgage loan, you simply trade the loan you currently have for a new one – hopefully with better terms. Some experts advise that if you can save between 1 and 2 percent on your interest rate, refinancing is generally worth your while.
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Why Do People Refinance Their Mortgages?
People refinance their mortgage loans for a variety of reasons. Maybe it’s to get a lower interest rate. Or perhaps they want to cut their monthly mortgage payment. Some might even tap into their home’s equity to make another large purchase. For example, they may want to finance a significant home remodel. Alternatively, they might want to finance a child’s college education, or even consolidate other debt.
Other homeowners want to pay the balance of their mortgage loan faster. Or they want to switch from an adjustable-rate mortgage to a fixed-rate loan. Whatever the reason, before you start the refinancing process, you should make sure you’re aware of what the process entails and how to decide whether it’s the best path for you.
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What Are the Steps For Refinancing a Mortgage?
Below we’ve outlined every step in the process of refinancing your mortgage loan.
Step One: Define Your Goal
Before you start the process, make sure you’ve clearly outlined what you want to achieve by refinancing your mortgage. Is it a lower monthly payment? Accessing your home’s equity? Switching from an adjustable- to a fixed-rate mortgage? Make sure you’re clear on what the outcome should be so that you’ll know when you’re successful.
Step Two: Calculate Your Home Equity
You must have an appropriate level of equity in your home to qualify for a refinance. The exception to this may be with some government programs. These allow homeowners with lower levels of equity an opportunity to refinance. In general, homeowners who have at least 20 percent equity in their homes are more likely to be approved. They will also get an interest rate that is favorable and worth their while.
One point you should keep in mind is that if you don’t have at least 20 percent equity in your home, you’ll be required to pay private mortgage insurance. This may not make a difference if you’re already paying PMI. But if your home has decreased in value since you originally purchased it, you may find yourself paying PMI for the first time. Make sure to do your research. Additionally, make sure you can cover those costs without the refinance losing its value for you. Any lender you’re considering should be able to quickly calculate how adding PMI will affect your monthly payment so that you’ll know what you’re in for.
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Step Three: Find Out Your Credit Score
As when applying for any loan, you should make sure you fully understand your credit score before starting the process. Your score will play a significant role in determining what kind of loan product and interest rate you’ll be offered. Make sure you know where your score falls. That way, you know which lenders and products might be best for you. Checking your credit report also allows you to correct any mistakes that might be artificially lowering your score.
Over the past few years, lenders have tightened their credit requirements. Therefore, even homeowners with good credit have been surprised that they don’t qualify for the best rates. If you’re looking for the lowest possible interest rate, you should shoot for a credit score of at least 760. This depends on what your credit score was when you originally qualified for your mortgage loan. Even a lower credit score than 760 could get you into a new loan with more favorable terms. It all depends on your specific circumstances.
Step Four: Calculate Your Debt-to-Income Ratio
In addition to your credit score, think about your debt-to-income ratio. Ideally, it would be under 36 percent to score the most favorable loan terms. Just because you already have a mortgage loan doesn’t automatically guarantee that you’ll qualify for a refinance. This is especially true if you’ve taken on additional debt since buying your home. Lenders generally want to see that all housing expenses fall under 28 percent of your gross household income. Additionally, that debt accounts for no more than 36 percent of your income.
If you currently don’t meet these thresholds, don’t lose heart. Other positive factors like a high income, hefty savings, and long and stable job history can also work to offset a high debt-to-income ratio. In some cases, a lender may accept a debt-to-income ratio as high as 43 percent.
Step Five: Get Pre-Qualified
Just as you did when you purchased your home, you’ll have to qualify for the new, refinanced mortgage. And just like when you bought your home, you’re in a much better negotiating position if you go through the process of getting pre-qualified. This can help you decide which lender might be able to offer you the best interest rate.
Step Six: Use a Mortgage Refinance Calculator
You can find a wide variety of mortgage refinance calculator tools through a simple online search. These will help you make some educated guesses about your desired interest rate and total loan amount. Playing with those numbers within a mortgage refinance calculator can allow you to see your new monthly payment. You can also see your lifetime savings, and your monthly savings, depending on the amounts you input.
Most mortgage refinance calculators also take into account the fees and other costs associated with refinancing. Additionally, they will show you your “break-even” point. That’s the point at which your savings will make the costs associated with refinancing the loan worth your while. For example, if your refinance costs you $3,000 and saves you $100 on your monthly payment, it will take you 30 months to recoup those costs in monthly savings. If you plan to move from your home before that point, the refinance isn’t necessarily a good financial move.
A mortgage calculator can be especially helpful when evaluating your pre-qualification offers. You can plug in the numbers from prospective lenders to see which offers you the best deal. Keep in mind that most loan refinances cost roughly from 3 to 6 percent of the total loan amount in closing costs and fees. Sometimes a lender will offer a “no-cost” mortgage refinance. This means that you’ll pay a slightly higher interest rate to cover closing costs.
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Step Seven: Shop Refinance Rates
At this point, since you know you’re pre-qualified, you can seek formal estimate letters from potential lenders. Once you’ve submitted your information, a potential lender is required to present you with a loan estimate within three business days. This estimate will outline everything from closing costs and fees to formal loan terms and projected monthly payments. Once you have all of your loan estimates, you can compare them side by side to choose the one that’s best for you. It’s usually a good rule of thumb to apply with three to five lenders. You’ll want to submit your applications within a two-week window to minimize the effect on your credit score.
Step Eight: Choose Your Lender
Based on the information in your loan estimates, you can choose the mortgage lender that gives you the best terms that meet your original goal for refinancing.
Step Nine: Lock in Your Rate
Once you’ve chosen your lender, they’ll lock in the interest rate for a specified period while you prepare to close. You and your lender will then work together to make sure you can close on the loan before the locked rate expires.
Step 10: Close on Your Loan
Closing on a mortgage refinance is exactly like closing on a home mortgage in the first place. You’ll sign lots of papers and pay all associated closing costs. The only difference is that you won’t receive a new home at the end of the process. Ultimately, you should have more money in your pocket!
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How Do You Know if Refinancing My Mortgage is Right For You?
As you’re considering refinancing your mortgage loan, the following reasons may point you toward refinancing as your best option:
Reducing Your Monthly Payment
By refinancing your loan, you typically do so at a lower interest rate, which helps reduce your monthly payment. When you refinance, you can also reduce the monthly payment by extending the life of your loan, but be careful. Doing so will cost you more in interest over the life of the loan.
The smartest move is to ask any potential lender to match the current terms of your loan. Stretching the loan term can dramatically lower your monthly payment. However, it will bite you in the long run in the form of thousands of dollars in extra interest costs over the life of your loan. This is what mortgage amortization looks like.
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Tapping Into Your Home’s Equity
When you refinance to borrow more than you owe on your home, the lender will issue you a check for the difference. This is called a cash-out refinance. Many people can get this benefit, plus a lower interest rate in the bargain. Many people use this option to either consolidate existing debt or to finance a large purchase.
But be careful – if not used wisely, this option can perpetuate a never-ending debt cycle. If you’re thinking about financing to pay off high-interest credit card debt, think long and hard about whether you can resist the temptation to keep overspending once the high-interest debt is paid. It’s a slippery slope.
Paying Off Your Loan Faster
Often people will refinance from a 30-year fixed-rate mortgage to a 15-year fixed-rate mortgage. This allows them to pay off the loan in half the time. This is one of the very best reasons to refinance your mortgage loan. The change will enable you to pay less in interest over the life of the mortgage loan. However, your monthly payment will likely increase. And in some cases, depending on the change in interest rate, your monthly payment may remain roughly the same, even though you’re slashing the loan life by half.
Getting Rid of FHA Mortgage Loan Insurance
Usually, Federal Housing Administration mortgage insurance premiums can’t be canceled like private insurance premiums. However, you can wipe out FHA mortgage loan insurance. You can do this by either selling your home or refinancing your mortgage once you’ve built up enough equity.
Switching From an Adjustable-Rate to a Fixed-Rate Mortgage
Many homeowners sign on for an adjustable-rate mortgage to take advantage of introductory savings. But once your initial period comes to an end, you run the risk of dramatically increasing interest rates. By refinancing to a fixed-rate mortgage, you can move your loan from an adjustable-rate to one with a fixed interest rate. This move saves you money in interest over the life of your loan. If you’re feeling anxious, a fixed-rate mortgage loan also provides you with the stability of knowing exactly what your payment will be for every month over the life of the loan.
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Overall, refinancing your mortgage loan can be a savvy financial step. However, make sure you’re doing it for the right reasons. Lowering your monthly payment, paying your loan off faster, and more quickly building equity in your home are all sound reasons to refinance and put you on a solid financial footing in the end. And if you use it prudently, a refinance can even be a great way to bring high-interest debt under control.
Have you ever refinanced a mortgage loan? Were you happy with your refinance rates? Tell us about your experience in the comments below.