Before refinancing your mortgage, look at interest rates, your financial situation, market conditions and your refinance options.
Lower mortgage interest rates or better terms may incentivize you to consider refinancing your home loan. If you've raised your credit score, even if interest rates are the same, you could save with refinancing. To help you get the best deal, we’ve asked experts for their top mortgage refinance tips.
A refinance could also help you access equity or secure better terms to restructure your finances, but the decision comes down to personal financial considerations. Read on for the best mortgage refinance tips to get started.
Identify the Purpose Behind Your Decision to Refinance
It’s important to identify the purpose behind your decision to refinance. Have interest rates dropped significantly? Did you raise your credit score?
Possible reasons to refinance:
- Access equity in the home, especially if it has appreciated.
- You can qualify for lower interest rates or better terms.
- You want a longer mortgage term.
- You need to access equity in the home.
Check Your Financial Health and Work on Improving It
Next, it’s important to check your financial health. Even if you have an existing mortgage, it doesn't mean you'll qualify for a refinance. You'll need to check your credit score and debt-to-income ratio. Here is why lenders check these numbers:
- Credit score: This tells lenders the statistical probability that you'll default on the loan. A higher credit score will increase your chances of approval and a lower interest rate, but some lenders could approve a refinance with a credit score of 620.
- Debt-to-income ratio: Your ratio of total income to debt tells lenders whether you can afford the loan. If you've taken on additional debt and your DTI has increased, you might not qualify for a refinance. As with a mortgage, a common benchmark is a maximum DTI ratio of 43% when refinancing.
Jason Lerner, area manager at First Home Mortgage, recommends sitting down with an experienced lender who can look at your financial situation and external factors. “It’s so critical to sit down with a lender who understands market conditions and how those affect you,” he says.
Understand Your Home Equity
Before refinancing, it's essential to understand your home equity. Equity is the asset value you've built up in your home. It considers both the payments you've made on the mortgage principal and any increase in the home's appraised value. Understanding your equity is essential to the success of your mortgage refinance application.
For example, suppose you bought the home for $300,000, and its appraised value five years ago was $300,000. You made on-time mortgage payments for five years and built up around $17,000 in home equity. But there's more. Suppose the home's value also increased to $340,000 in that time. Now, instead of having $17,000 equity in the house, you will have $57,000 in home equity.
On the other hand, if your home is worth less now than when you bought it, you may have negative equity, making it difficult to refinance. If you have at least 20% home equity, you'll have an easier time qualifying for a mortgage refinance, especially if you’re going for a cash-out refinance.
Lerner says you can have as little as 5% equity for simple rate-and-term refinances. “People talk about 20% and that’s mainly true only if you’re looking to pull equity,” he says. “For other cases, 5% is the magic number.”
You can learn how to calculate your home equity here.
Factor in the Closing Costs
Closing costs when you refinance a mortgage are between 2% and 6% of the total loan amount, though you may be able to roll some or all of them into your mortgage. These costs cover the home appraisal and loan underwriting process.
For example, you can roll the costs into your new loan with enough equity. In addition, some lenders offer a no-closing cost refinance, but you will pay for that with a higher interest rate that covers closing costs.
Closing costs can be fixed fees or a percentage and include:
- Loan application fee: $75 to $500
- Home appraisal: $225 to $700
- Credit report fee: $10 to $100 per applicant
- Document preparation fee: $50 to $600
- Title search/insurance fee: $400 to $900
- Loan origination or underwriting fee: 0% to 1.5% of loan
- Mortgage insurance: 0% to 3.6%, depending on mortgage type and equity in the home.
Shop Around With Multiple Lenders
Since closing costs are the biggest new expense in a mortgage refinance, it's important to shop around and compare lenders. You could qualify for better terms, interest rates or lower closing costs. The difference between 2% and 6% of a $300,000 mortgage could mean savings of $12,000.
“I recommend starting with the loan officer who gave you your original mortgage,” Lerner says. “Not necessarily the company or institution, but the individual you sat down with at that time.”
Choose Between a Fixed-Rate Mortgage or Adjustable-Rate Mortgage
Each time you get a mortgage, you must choose between a fixed-rate mortgage and an adjustable-rate mortgage. Choose a fixed-rate mortgage if you plan to stay long term to avoid the risk of rising interest rates later. On the other hand, consider an adjustable-rate mortgage if you plan to move soon and the current offered adjustable rate is favorable.
Calculate the New Monthly Payment and Ensure Affordability
You can use a mortgage calculator to input the new mortgage amount, interest rate and any mortgage insurance or tax changes.
For example, if you were paying $2,000 a month on your existing mortgage and you want to refinance for $275,000 with the current 7% interest rates, you'd end up paying $1,829.58 a month without accounting for property tax, insurance and PMI or MIP.
Should you refinance in that case? If your previous $2,000 payment included these, you're likely better off staying with your existing mortgage. If not, you could save about $170 a month, but after accounting for closing costs, it may not be worth it.
Time Your Refinance Application
Of course, when interest rates are exceptionally high, it's not the best time to apply for a refinance. Timing your refinance application to favorable rates can help you find the best deal. Most mortgage lenders allow you to lock in the rate for up to 30 days, with some offering longer periods. This gives you time to complete the underwriting process and secure a better interest rate.
Most experts recommend refinancing when rates have dropped 1%, though Lerner says that’s not true for everyone. “You’ll need to take a holistic look at your loan size and the market conditions,” he says. “Depending on the size of your loan, it could be much larger than 1% before it makes sense to refinance.”
Be Cautious of No-Closing-Cost Refinances
A no-closing-cost refinance is a type of refinance that rolls the closing costs into the mortgage and typically offers a higher interest rate. Carefully compare rates and proceed cautiously, as you'll typically end up paying more in monthly mortgage payments for the convenience of no upfront payments.
Ensure Upgrades are Easily Accessible
If you've made home upgrades that can increase your home's appraised value, it's important to make them easily accessible for the appraiser. The appraised value is the basis the lender will use to determine your equity in the home and, thus, the loan amount, terms and whether you need PMI.
Prepare Yourself for a Successful Appraisal
A house appraisal looks at the structure of the home, as well as the neighborhood and comparable homes, to determine its current market value. You can get a free or low-cost house appraisal that compares your property with recently sold homes in the area. However, you will need an official home appraisal for loan approval.
Aim for a Break-Even Point Within 2-3 Years
When you see $250 in monthly savings, that may seem amazing. But if you're paying $12,000 upfront for those savings, it's unlikely to be the best financial move, even if you're rolling the difference into the mortgage.
That's where calculating your break-even point comes in. The break-even point in the case of a mortgage refinance is how long it takes to recoup your closing costs and start saving. In the example above, you'll save $3,000 a year on mortgage payments. If you paid $12,000, your break-even point is four years.
Aim for a break-even point within two to three years. In this example, you could shop around with different lenders. If you find a lender offering the same interest rate but with just $6,000 in closing costs, your break-even point would drop to two years. This can be a good financial move if it makes sense for you in other ways.
Be Prepared to Pay for Private Mortgage Insurance
If you refinance your home with less than 20% equity, you might have to pay for private mortgage insurance (PMI). This is true for conventional loans, while federally backed USDA, VA or FHA loans have their own qualifications but usually charge some form of mortgage insurance for borrowers with less than 20% equity.
For many borrowers, the reduced monthly payments from a refinance won't be low enough to offset the additional cost of PMI. A lender can quickly calculate whether you must pay PMI and its effect on your monthly mortgage payments.
Lerner, however, says PMI costs are not as big of a concern as they once were. “For a well-qualified borrower, it’s become extremely affordable,” he says.
Impact on Your Taxes
If you've been deducting mortgage interest payments from your tax bill, a refinance can reduce the amount you can save on taxes. While you may be paying less interest, you will have to pay more taxes. However, most people don't consider this a reason to avoid refinancing.
Deciding When to Refinance
Deciding when to refinance comes down to looking at your total financial picture, home equity and break-even point. Refinancing can be a good idea if you can save on monthly mortgage payments and the break-even point is under three years. Be sure to shop around and research lenders to find the best available rates, and carefully compare your monthly payments with all interest and fees. You can find some of the best mortgage refinance lenders and get started.
What to Know Before Refinancing a Home Mortgage
- Mortgage refinancing can help you save on monthly mortgage payments.
- Considering home equity and the break-even point is important before deciding to refinance.
- A lender can tell you whether you will need PMI and help you estimate monthly payments.
- Carefully research and compare all factors and lenders’ offers before refinancing.
Why You Should Trust Us
Benzinga has offered investment and mortgage advice to more than one million people. Our experts include financial professionals and homeowners such as Anthony O’Reilly, the writer of this piece. Anthony is a former journalist who’s won awards for his New York City economy coverage. He’s navigated tricky real estate markets in New York, Northern Virginia and North Carolina.
For this story, we worked with Jason Lerner, area manager for First Home Mortgage and a 22-year veteran of the mortgage industry.
Frequently Asked Questions
What is the 80/20 rule in refinancing?
The 80/20 rule in refinancing states that the loan-to-value ratio, or the loan amount divided by the house’s market value, must be 80% or lower and that you have at least 20% equity. This is more of a guideline and isn’t required by all mortgage lenders.
At what point is it not worth it to refinance?
It’s not worth refinancing your home mortgage if current interest rates are higher than when you first secured your home loan or if refinancing results in a higher monthly payment.
How much are closing costs on a refinance?
The average closing costs to refinance a mortgage are between 2% and 6% of the total loan amount.
Sources
- Jason Lerner, area manager for First Home Mortgage and a 22-year veteran of the mortgage industry
About Anthony O'Reilly
Anthony O’Reilly is an updates editor for Benzinga. He’s won numerous journalism awards for his coverage of the New York City economy and Long Island school district budgets.
