Guide to refinancing your home loan
You might have thought that once you bought your house and took out a 30-year mortgage, you would never have to apply for a mortgage again. After a few years, however, you may decide that it makes sense to refinance your home loan. Here’s what you need to know:
What is mortgage refinancing?
Refinancing a mortgage means you get a new home loan to replace your existing loan. If you can refinance a loan that has an interest rate lower than what you are paying now, you may be able to save money. The best time to consider refinancing is when interest rates drop sharply and fall well below where they were when you closed your original mortgage. Another good opportunity is when your credit improves to the point where a new loan has a lower interest rate.
Generally, it’s worth considering refinancing if you can lower your interest rate by at least half a percentage point and plan to stay in your home for at least a few years. You can find and shop for refinance lenders in your area.
Why you should consider refinancing
There are a variety of reasons that may make financial sense to refinance your home loan:
- To reduce your monthly mortgage payments by obtaining a lower interest rate
- To get a shorter term, like a 15-year loan to replace a 30-year mortgage, so you can pay it off faster and pay much less total interest
- Switching from an adjustable rate home loan to a fixed rate loan – a good idea if you think rates will increase in the future
- To extract money from the equity in your home in what is called a refinancing with withdrawal
- Eliminate Mortgage Loan Insurance If You Have Accumulated 20% of Your Home Equity
How to refinance your mortgage
The refinancing process is similar to getting a mortgage when you buy your home.
STEP 1: SET A CLEAR FINANCIAL GOAL
There should be a good reason you’re refinancing, whether it’s to lower your monthly payments, shorten your loan term, or withdraw equity for home repairs or debt repayment.
Things to consider: If you lower your interest rate but start over for the duration of a 30-year mortgage, you could end up paying less each month, but more over the life of your loan. This is because the bulk of your interest costs are in the first few years of a mortgage.
STEP 2: CHECK YOUR CREDIT RATING AND HISTORY
You will need to qualify for refinancing, just like you would need to get approved for your original home loan. The higher your credit score, the better the refinancing rates lenders will offer you, and the better your chances of underwriters to approve your loan.
Things to Consider: It may be a good idea to spend a few months improving your credit score before you begin the refinance process.
STEP 3: DETERMINE HOW MUCH HOUSEHOLD EQUITY YOU HAVE
The equity in your home is the value of your home that is more than what you owe the bank on your mortgage.
To find out, check your mortgage statement to see your current balance. Then check out online home search sites or have a real estate agent run a scan to find your home’s current estimated value.
The equity in your home is the difference between the two. For example, if you still owe $ 250,000 on your home and it is worth $ 325,000, your home equity is $ 75,000.
Things to consider: You may be able to refinance a conventional loan with as little as 5% equity, but you’ll get better rates and lower fees if you have more than 20% equity. The more equity you have in your home, the less risky the loan is for the bank or lender.
STEP 4: SHOP MULTIPLE LENDERS
Getting quotes from multiple lenders can save you thousands of dollars. Once you’ve chosen a lender, discuss the best time to lock in your rate and not have to worry about the rate going up before your loan closes.
Things to Consider: In addition to comparing interest rates, pay attention to the cost of the fees and whether they will be owed upfront or built into your new mortgage. Lenders sometimes offer “loans with no closing costs” but charge a higher interest rate or add to the loan balance.
STEP 5: BE TRANSPARENT ABOUT YOUR FINANCES.
Gather recent pay stubs, federal income tax returns, bank statements, and whatever your lender asks for. Your lender will also look at your credit and equity, so disclose your assets and liabilities up front.
What to consider: Having your documentation ready before you begin the refinancing process can make it smoother.
STEP 6: PREPARE FOR THE EVALUATION.
Some lenders may require an appraisal to determine the current market value of the home for refinancing approval.
What to consider: You will pay a few hundred dollars for the evaluation. Notifying the lender of any improvements or repairs you have made since purchasing your home could result in a higher valuation.
STEP 7: COME TO THE CLOSURE WITH MONEY, IF NECESSARY.
The closing disclosure, along with the loan estimate, will indicate how much money you have to pay out of pocket to close the mortgage.
Things to consider: You may be able to finance these costs, which are usually a few thousand dollars, but you will likely pay more with a higher rate or loan amount.
STEP 8: KEEP A LOOK AT YOUR LOAN.
Keep copies of your closing documents in a safe place and set up automatic payments to make sure you stay up to date on your mortgage. Many lenders will also offer you a lower rate if you sign up for automatic payment.
Things to consider: Your lender may resell your loan in the secondary market immediately after closing or years later. This means that you will owe mortgage payments to another company, so keep an eye out for mail informing you of these changes.
Benefits of refinancing your mortgage
- Free up money every month. A rate and term refinance replaces your mortgage with a new, lower rate loan, which means you have to pay your lender less each month.
- Pay for your house faster. You may be able to refinance a loan with a lower interest rate and a shorter term. The savings on interest payments could be substantial, for example, if you are able to refinance into a 15-year mortgage from a 30-year loan. However, if you invest more money in paying off your mortgage, you may have less money for expenses like saving for retirement, college, or an emergency fund.
- Eliminate private mortgage insurance. If your initial down payment was less than 20 percent, you probably paid private mortgage insurance, or PMI, additional fees on each payment. If rising home values and your loan repayments have pushed your home equity above 20%, you may be able to refinance a new loan without a PMI.
- Tap the equity in your home. Homeowners with at least 20% of their home equity sometimes turn to cash refinancing. This is when you refinance your home loan into a new mortgage for a larger amount, to meet a specific financial need and receive the difference in cash. This can make sense if you plan to use the money to reinvest in your home as part of a major renovation project or to pay off high interest debt.
- Lock in a fixed rate mortgage. If you are in an adjustable rate mortgage that is about to reset and you think interest rates are going to rise, you can refinance into a fixed rate loan. Your new rate may be higher than what you are paying now, but you can rest assured that it will not increase in the future.
Risks and costs of refinancing your mortgage
While refinancing can be a smart move, it’s not for everyone. Refinancing can be a mistake if you are unable to lower your interest rate by much or incur a lot of expense. Here’s what to keep in mind:
- Refinancing is not free. Your refinanced mortgage has fees, such as origination fees, appraisal, title insurance, taxes, and other fees, just like your original mortgage. Even though the refi results in a lower monthly payment, you won’t save money until the monthly savings outweigh the cost of refinancing. You will need to do some math to determine how many months it will take you to reach that breakeven point. If there is a chance that you will be moving before then, refinancing is probably not the best solution.
- You may have a prepayment penalty. Some lenders charge you additional fees for prepaying your loan amount. A high prepayment penalty could tip the balance in favor of maintaining your original mortgage.
- Your total financing costs may increase. If you refinance a new 30-year mortgage, you’re likely going to pay a lot more interest and fees over the life of your loan than if you had kept the original mortgage.
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This story was first published on November 21, 2019.