Refinancing your mortgage can offer a lot of financial benefits. Home values are still relatively strong, and interest rates remain low. Many homeowners choose to refinance these days. Benefits to refinancing an existing mortgage can include lowering your monthly payment, locking in a better interest rate for the life of your loan, and “cashing out” some of your equity.
As you consider refinancing, the most important question to answer is whether it is the right option for you at this time. Here are some of the most important things to consider before you start a refinance.
Understand how much equity you have in your home and your home's value. Your equity is what you actually own of your home (versus what the bank may own). Your equity would include the amount of the principle you have already paid down and, potentially, the increased value of your home since your first mortgage. It would be best to have at least 20% equity of your home's overall value to make it easier to qualify for a refinance loan.
When you pursue your refinanced loan, there will be an official appraisal of your home to determine its value. If you are exploring a refinance and want to get an estimate of your home's value, you can use home search sites like Zillow.com to provide you with your estimated value, as well as sites like PennyMac, which will also show you the value of homes that have recently sold in your area. Depending on when you took out your last mortgage, how much you have done to your home, and the property values in your area, your home could have accrued a significant amount of value over time.
Understand your credit score and debt-to-income ratio. While you may not be able to control your property's value, your credit score and debt-to-income ratio are two things within your control that can have a significant impact on your ability to refinance. You can request your credit report online through one of the three credit bureaus (Equifax, TransUnion, and Experian) at any time to evaluate if your financial situation is strong enough for a refinance at this time. You will typically need a FICO credit score of 760 or higher to qualify for some of the low-interest rates you see advertised on promotional materials. You may be able to obtain a refinance loan offer if your score is lower but be aware that your interest rate may not be significantly better than your current interest rate.
Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number has become increasingly important as it is how lenders measure your ability to manage the monthly payments to repay the money you plan to borrow. The Consumer Financial Protection Bureau recommends that you have no more than a 43% debt to income ratio when applying for a mortgage loan. Some lenders may require a lower debt to income ratio to qualify for the best rates.
Understand the associated costs of the loan and your “break-even” point. Every loan will have closing costs (usually between 3 – 6% of the loan's total value), including the application fee, appraisal costs, title insurance, and lender points, which prepaid fees lenders charge for their work in preparing and evaluating a mortgage loan. Your closing costs will typically be wrapped into your loan. If your credit score and finances are in good shape, the more likely you will be able to “shop around” for lower closing costs.
Another number you want to be aware of as you evaluate offers is your “break-even” point when taking on a new loan. Your break-even point occurs when you begin saving money — in other words when your accumulated savings exceed the new loan's costs. You can determine this by dividing the total loan costs by the monthly savings.
So, if your refinancing closing fees will total $3,000, and you will save $100 a month. Divide $3,000 by $100. The answer is 30. That means it will take 30 months to recoup the cost of refinancing. There's your break-even point. While there are other factors to consider when refinancing, if the number of months you will pay on your new refinance significantly exceeds the number of payments that remained on your current loan, you could be paying a lot of extra interest. If you have an offer you are considering, NerdWallet has an easy refinance calculator that will show you the “break-even” point for you.
Understand why you want to refinance. This sounds pretty basic, but when you weigh your reason for refinancing against some of the other factors, it can help you determine if now is the best time or you to refinance.
The most common reason to refinance a mortgage is to get a lower monthly payment, which can be achieved by:
- Securing a lower interest rate as people typically refinance when interest rates are low
- Extending the life of your mortgage to break your overall loan into smaller payments over a longer period of time
- Eliminating required mortgage insurance if you have built up more than 20% equity in your home since your first mortgage. Many companies require homeowners to carry mortgage insurance if you have – or can pay (in a down payment) – less than 20% of the home's value.
Many also choose to refinance their mortgage to “cash-out” some of their equity and pay off other bills, especially things like high-interest credit cards. Homeowners may also want to put that cash toward making home improvements– which is smart as it will increase the home's value (and equity).
Applying for your loan
If you determine that refinancing your mortgage will help you meet your financial goals, the process itself is pretty straightforward nowadays. You can go to your existing lender, but most experts will tell you to shop around for the best deal. Many sites will compare offers after you plug in some information about your home. The Federal Trade Commission (FTC) even has a handy Mortgage Shopping Worksheet to help you evaluate each loan. Different offers will include estimates on interest rates, closing costs, and your monthly payment.
Once you find an offer that works for you, you will need to apply officially. You can likely complete most of this process online through a lender's secure server. This process will include uploading important documents to prove your income and assets, including:
- the last couple of months of bank statements
- recent pay stubs and
- prior-year tax returns and W2's.
If you are applying jointly with someone, like your spouse, you will also need to make sure you have their information, as well. You may be asked for additional information, depending on your situation, like documents on child support, investment dividends, or Social Security payments.
You will also want to make sure that your home is ready for the appraisal, which will determine your home's official value for the loan. Low-cost projects like decluttering your rooms, deep cleaning, repainting, adding some new décor like curtains or new faucets as well as tidying up your yard will help your home look more valuable. It's also a good idea to make a list of all your recent home repairs and upgrades to share with the appraiser, including replaced HVAC units, siding, gutters, a new roof, remodeled kitchens, and updated bathrooms.
If you have taken all of these factors into account and feel good about your financial position, your home's current value, and your ability to secure a better mortgage loan, then you are ready to explore refinancing your home.
