Guidelines to Refinance a Mortgage

You’ve heard about the benefits that can come from a mortgage refinance, like getting a lower interest rate that can save you money on your monthly mortgage payments, helping you afford home renovations or even getting your finances back on track if done correctly.

But how do you know if refinancing your mortgage is right for you? Start by asking yourself four questions to find out if a mortgage refinancing is the right option for your situation.

1. Why Do You Want to Refinance?

The first step in determining whether or not to refinance your mortgage is to ask yourself what your reason for refinancing is and what you hope to gain. Do this before you talk with a lender or apply to refinance.

There are a lot of reasons to refinance your home loan. Here are a few and when each might be a good option.

To get a lower interest rate. Generally, if refinancing will lower your interest rate by at least 2%, it’s a good idea. If interest rates are low, especially if they’re lower than the rate on your initial loan, it’s possible that refinancing your mortgage could lower your monthly payment and the overall cost of your loan.

To move to a different type of loan. If you currently have an adjustable-rate mortgage (ARM), you may want to switch to a fixed-rate mortgage in order to lock in the lower rate for a longer period of time. Refinancing makes that possible. Alternately, you may be able to reduce your current payments by switching from a fixed-rate mortgage to an ARM.

To avoid a balloon payment. Some mortgages have a large payment due at the end of the loan term-usually at five to seven years. You may want to refinance your loan in order to avoid having to pay a balloon payment.

To stop paying private mortgage insurance. Private mortgage insurance (PMI) is sometimes required by lenders if you borrow more than 80% of the home’s sale price—in other words, don’t make a 20% down payment. PMI can usually be removed once your loan-to-value ratio hits 78% of your home’s original value. That 78% mark can be reached by your paying down your loan. Refinancing is another alternative to getting out from under PMI. If your home has gone up in value, you can refinance without needing PMI because the new value will cover your 80% down compared to your refinanced loan.

To get cash out of your home’s equity. A cash-out refinance lets you refinance for more than you owe on the original mortgage and get cash in hand. That cash can be used to finance a remodeling project, college tuition, car purchase, a vacation or anything else you want to use it for.

To consolidate debts. If you have a high-interest debts, you may be able to save by consolidating these debts into a refinanced mortgage loan.  Auto loans, credit cards, second mortgages and other debts can be included in your refinance.

2. How Are Your Finances?

Before you start filling out the refinancing paperwork, think about your current financial situation, including your credit. If you haven’t checked your credit in a while, now is the time to do so.

You can get free copies of your credit reports from the three main credit reporting bureaus—TransUnion, Equifax and Experian—at annualcreditreport.com once a year. You can also see your Experian credit score for free on Credit.com.

Things to consider about your financial situation and how they might impact whether or not to refinance include:

Have your credit and finances improved? If your credit score has improved since your last mortgage application, you may be able to reduce the interest rate on your loan by refinancing. You can also save by refinancing if other financial indicators, such as your debt, income, and savings, are better than they were when you took out your mortgage.

Have your credit and finances stayed the same? If your credit scores and financial situation haven’t changed since you first got your mortgage, you may or may not be able to save by refinancing. That doesn’t mean you shouldn’t look into a refinance. But it’s a good idea to look at recent interest rate changes and consider your reasons for refinancing before you apply.

Have your credit and finances gotten worse? If your credit score has gone down, you may not be able to save money by refinancing. Even if interest rates have dropped, you may not qualify for the lower rate because of your reduced credit score.

Estimate what mortgage rates you could receive based on your credit scores and consider your reasons for refinancing before you apply. You may also want to take steps to improve your credit score, like being more diligent about making on-time payments, paying down debt and fixing errors on your credit reports.

3. How Much Will It Cost to Refinance a Mortgage?

While a lower interest rate can mean lower monthly payments and less money out of your pocket for the life of the loan, most refinance options require paying closing costs and, in some cases, mortgage points-fees that go to the lender in exchange for a lower interest rate. If your monthly savings exceeds these costs, refinancing can be a good option.

Keep in mind the associated costs vary from lender to lender, so be sure to shop for the best mortgage refinance options available to you. Get a loan estimate from each lender. Each estimate details the loan terms, projected payments and estimated closing costs and fees. Potential mortgage lenders legally have three days to get an estimate to you once they have your information.

4. Are There Reasons Not to Refinance?

Just like with any other financial decision, do your research to make sure a refinance is right for you. Sometimes it’s not the best route. Above all, if you won’t save money once the closing costs and other expenses are considered, refinancing might not be worth your time and effort.

Other factors to consider:

You’re moving soon. It takes a year or two to break even on the costs of refinancing. So, if you know you’ll be packing boxes by the time you break even, consider reconsidering changing the terms of your loan.

Your loan has a prepayment penalty. Some loans include prepayment penalties. These penalties charge expensive fees if you sell or refinance your home before a certain amount of time has passed—typically one to five years from the original loan date. If this is your situation, you can calculate if the savings you’ll see from refinancing outweigh prepayment penalty fees. If not, you may want to hold off on refinancing and reevaluate once your prepayment penalty deadline has passed.

You’re close to paying off your mortgage. If you’re close to paying off your mortgage, it may make sense to wait instead of refinancing—even if the terms on a refinance are better than your current terms. Refinancing can extend the term of your loan and increase your costs, which makes refinancing not worth your while in the long term—especially since you’ll pay closing costs to refinance.

You’re having financial problems. If you’re having financial problems, reconsider refinancing. While refinancing may seem like a good way to consolidate your debts or borrow money. In some situations, it could be put at risk if your financial problems persist.

How Do I Qualify to Refinance?

Typically, mortgage refinancing options are reserved for qualified borrowers. You, as the homeowner, need to have a steady income, good credit standing and at least 20% equity in your home. You have to prove your creditworthiness to initially qualify for a mortgage loan approval. And you have to do the same for mortgage refinancing.

Know how much home equity have. One of the biggest things you need to consider is the equity in your home. If you find that you’re left with little to no equity in the home several years after the purchase, refinancing may not make sense. You need at least 5% equity to make refinancing a viable option—the more the better.

Take a close look at your debt-to-income ratio. Your debt-to-income ratio tells the lender if you can afford your new monthly mortgage payment. Mortgage lenders say that the total new monthly mortgage payment shouldn’t be more than 30% of your total gross monthly income. The total debt of your household should also fall under the 40% threshold when refinancing a mortgage.

Do you have liens or a second mortgage? When you refinance, the new loan is used to pay off your first and initial mortgage. If you have liens on your mortgage or a second mortgage, refinancing can be challenging. You want to resolve any involuntary liens, such as tax liabilities before you try and refinance.

If you have a second mortgage, that lender gets paid first if you refinance. If you were to default on your home loans, this puts the refinance lender at risk. This can pose challenges to refinancing when you have a second mortgage. Your best option may be to pay off the second mortgage before you refinance or consolidate both loans into your refinance loan.

Do you owe more than your home could sell for? If you owe more than your home is worth, consider other options or wait to refinance later. Options include talking to your lender about adjusting your restructuring your existing mortgage to lower your payments and other options on the table, if any.

Bottom Line on Refinancing a Mortgage

Refinancing isn’t for everyone. But if you have a good reason, meet the qualifications and can be financially responsible for your new mortgage payment, refinancing may be an option to put yourself in a better financial position.

This article was last published December 9, 2016, and has since been updated by another author.

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