Whether you feel dissatisfied with your current loan terms or you want to take advantage of using some of the equity you've built up in your property, you might look into refinancing your home. The process involves taking out a new home loan to pay off the current mortgage, and you have different refinance options to consider depending on your financial goals. However, it's important to be sure you'll benefit financially from refinancing before going through the whole process.
Here's what you should know about refinancing your home, how to decide to do so and what the process looks like.
What Happens With Refinancing?
Whether you go through the same lender who gave you the original mortgage or shop around for a new lender, the refinancing process requires a new application process since you'll take out a new home loan that replaces the original mortgage. This means you could get a different type of mortgage, a new term, a different interest rate structure, a different mortgage payment and potentially even some funds from your home's equity.
Lenders usually consider you for a refinance when you can meet the financial requirements and have a home with enough equity to make the process worthwhile. The refinance process involves similar steps as a traditional mortgage, so you'll probably need to get an appraisal, submit documents and pay closing costs. Once your refinance gets approved, the lender handles the payoff process for the old home loan and disburses any funds owed to you, and then you start making payments on the new loan.
Read More: What Is Mortgage Refinance?
Exploring Types of Refinance Options
When exploring your options for refinancing, you'll usually come across these three refinance types:
- Traditional rate and term: This most common type of refinance allows you to take advantage of lower interest rates, change your mortgage's term or switch from a fixed to an adjustable-rate mortgage. For example, if you want to minimize interest charges, you might refinance to get a mortgage with a shorter term and lower interest rate, especially if you have good credit and rates have fallen since you originally took out the loan. On the other hand, you might seek a lower monthly payment by going with a new loan for a longer term or going with an adjustable-rate mortgage with a low initial rate. You can find streamline programs with this option that can speed up the application process and reduce requirements.
- Cash-in refinance: Less common than the other refinance types, this option involves contributing a large sum of money at the time of the refinance so that you can reduce the principal and save on interest by having a lower loan-to-value ratio. Usually, people who choose this mortgage refinancing option already have a good amount of equity in their homes to make it beneficial.
- Cash-out refinance: As a common option for people who have built up substantial equity, a cash-out refinance can help you get needed cash for financial goals like upgrading your home, paying off bills, covering educational expenses or even buying other properties. Usually, you can take out the new loan for a maximum of 100 percent of the current home value, and you'll get the cash you decide to take out of the equity when you complete the closing process. This option does come with the risks of additional interest plus potential foreclosure versus other types of loans.
Benefits of Refinancing Your Home
The benefits of a mortgage refinance depend on your financial situation and the type of mortgage you take out. The potential to save money over the long term or at least have a more affordable mortgage payment is a common reason why people seek a refinance. The possibility of getting cash from equity can also have an appeal.
If you refinance when mortgage rates are low and when your credit score is high, you can both save on monthly payments and interest overall. Considering a switch between mortgage rate structures allows you to adjust your strategy based on current rates and your preferences for risk. Going with a shorter term might mean higher payments but can ultimately save you money due to paying less interest.
Refinancing to borrow from equity offers the benefit of a lower interest rate than seeking financing elsewhere. It can also be a simple way to get the funds you need while allowing for a long repayment period you don't get with alternatives like personal loans.
Drawbacks of Refinancing Your Home
The costs and risks associated with refinancing mean you should analyze your situation to make sure the decision makes sense for you. Often, a refinance can seem less appealing in cases where you're far into your current loan term or won't stay in the house long enough to see savings from things like interest rate changes.
Like with a traditional mortgage, a refinance loan usually comes with closing costs, and these can reach up to 6 percent of the loan amount. You need to have this cash saved up unless your lender provides alternatives, like rolling the costs into the loan. Doing that means it will take some time before you break even after closing costs and actually see financial benefits from the refinance. Further, you can face prepayment penalties for having the original loan paid off early.
There are risks that you might not qualify for a refinance or that you could end up in financial trouble with options like cash-out refinances. You need to carefully consider refinance requirements to make sure you can get better rates. Also weigh the risks of borrowing against equity since you can end up with a higher mortgage payment and potential for foreclosure.
Deciding Whether to Refinance
To decide whether you should proceed with refinancing your home, you can use a mortgage refinance calculator like the one available through Citizens Bank. This type of calculator helps you determine the breakeven point. This term refers to how long it will take to see potential savings in your monthly payment, private mortgage insurance (PMI) and interest with consideration to the closing costs you need to pay for the refinance.
To get started, gather the following information:
- Current loan terms: Check your mortgage documents to get your original loan amount, term and interest rate as well as the number of years of payments left.
- Your income tax rate: Since the calculator considers tax benefits in the calculation, you need to know your current income tax rate.
- Appraised home value: Check with your local tax assessor to find both the original and current appraised values of your home.
- Potential refinance terms: You need an estimated interest rate and loan term as well as the balance you plan to refinance.
- Estimated refinance fees and closing costs: This means estimating a loan origination fee, closing costs amount and any points you plan to pay to reduce the interest rate.
After you input this information, you'll see some results in the number of months for various breakeven points. One of these usually includes how long it takes for the monthly payment savings to outweigh your closing costs, while others consider savings in PMI and interest and tax benefits. You also get an estimate of your new monthly mortgage payment, total interest paid and the overall savings you gain. This information along with your credit profile and financial situation can help you decide whether to proceed with preparing for the refinancing process.
Preparing for a Refinance
Like with applying for a regular mortgage, refinance loans require meeting several requirements, and they have some special considerations as well.
Here are some of the factors lenders look at when you start the preapproval process:
- Credit score: Unless you're applying for certain streamlined refinance programs, you usually need to have a credit score that meets or exceeds the minimum for the loan program. For example, this number usually is 620 for conventional, 620 for Veterans Affairs (VA) and 580 for Federal Housing Administration (FHA) refinance programs. Lenders might look for a higher number if you're doing a cash-out refinance. Not only does your credit score matter for qualifying to refinance, but the number affects your new interest rate and eventual savings versus keeping your existing mortgage too.
- Debt-to-income (DTI) ratio: Like with needing a certain credit score, your lender might not have a minimum DTI for some streamlined programs, but otherwise the maximum can range from 41 to 50 percent depending on the program and lender. Overall, the lender wants to make sure you have a sufficient and stable income that you can verify, and that you already aren't strained with debt. If you have a lot of cash saved, you may experience more flexibility with the DTI requirement for your refinance.
- Available cash reserves: While you might be able to roll closing costs into the refinance loan or avoid them in exchange for a higher interest rate, otherwise the lender will want to see 2 to 6 percent of the refinance loan amount on hand in your cash reserves. You need to show proof of this in the form of account statements.
- Length of homeownership: Homeowners usually need to wait six to 12 months after taking out a mortgage before refinancing.
- Home equity: While some streamlined and VA loans don't require it, others want to see that you've built up equity in your home. The minimum can range from 5 to 20 percent, and you can determine equity by looking at your loan-to-value ratio. Divide your remaining mortgage amount by your home's current value to get the LTV ratio; then subtract the percentage version of that number from 100 to get your equity. For example, owing $120,000 on a property worth $200,000 gives you an LTV ratio of 0.6, or 60 percent. After subtracting that result from 100, you'd have 40 percent equity in the property.
Read More: Can You Refinance if You're Newly Married?
Looking at Your Options
Once you know you'd like to pursue refinancing and know the type that interests you, you can begin looking for a lender. While you can go with your existing lender, consider shopping around to see what refinance loan rates you get through different options to maximize your savings. You can go through the preapproval process to get information about specific terms to help you decide on the best lender.
You can also get recommendations from the lenders for different refinance mortgage types like conventional, VA and FHA loans, since these will vary by credit score requirements, fees, rates and DTI ratios. For example, FHA loans allow for a lower credit score than the other options, while conventional refinance loans can give you a lower interest rate. There are also streamline programs with the government-backed options that can save you some hassle during the process.
Going Through the Refinancing Process
Once you've done your research, you can expect to go through these steps for the mortgage refinance process:
- Get preapproved: You submit an initial application to the chosen lender with property information (current loan terms and property value), personal financial information (income, cash reserves, debts and other assets) and the desired refinance type. Often, this means submitting documents verifying this information and undergoing a credit check. Then you get an answer about whether you can continue the application process and what the loan terms would look like.
- Proceed with refinancing: Carefully review the potential refinance terms and plug the information into a mortgage refinance calculator to see the breakeven point you can expect. If you like the terms, you can expect to contact the lender to lock in the given interest rate and continue with the underwriting process. Your lender will have you review and sign loan forms and verify your property and financial information. They may request additional documents from you and arrange for additional tasks, such as a home appraisal, to determine your home's current market value.
- Arrive at the closing stage: When the underwriter has everything in order and closing can start, then you need to have any upfront closing costs ready. At the closing meeting, expect to provide the funds and fill out the last paperwork to finish the refinancing process. Your lender explains the next steps about obtaining any cash-out funds and making the new mortgage payments.
- Washington State Department of Financial Institutions: Mortgage Refinancing Basics
- Value Penguin: Average Cost of a Mortgage Refinance: Closing Costs and Interest Charges
- Federal Reserve: A Consumer's Guide to Mortgage Refinancings
- Rocket Mortgage: Refinancing Your Mortgage: Requirements Explained
- Consumer Financial Protection Bureau: How Does My Credit Score Affect My Ability to Get a Mortgage Loan?
- Lending Tree: Understanding Mortgage Refinance Requirements
- Consumer Financial Protection Bureau: What Is a Debt-to-Income Ratio? Why Is the 43% Debt-to-Income Ratio Important?
- Consumer Financial Protection Bureau: What Fees or Charges Are Paid When Closing on a Mortgage and Who Pays Them?
- Benefits.gov: Cash-Out Refinance Loan
- Consumer Financial Protection Bureau: Understand Loan Options
- MyCreditUnion.gov: Refinance or Modify
- Consumer Financial Protection Bureau: What Is a Mortgage "Closing?" What Happens at the Closing?
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.