Are you thinking about refinancing your mortgage but don’t know where to start? Are you a little iffy because you're wondering how does refinancing a mortgage work? Maybe you’re just overwhelmed with information, or you feel like you’re missing out because it seems like everyone is refinancing their mortgages this year.
With a ton of mortgage resources at your fingertips, and knowing what to look for, refinancing is easy. What you just need to know is if a refinance is right for YOU.
Let’s take apart the simple factors involving home refinance and show you what to look for before you sign on the dotted line.
Right, but how does refinancing work?
Refinancing is what happens when you take out one loan at a lower interest rate to pay off another. (This is different than debt consolidation, which doesn't apply to loans like mortgages and student loans, read about the difference here.)
- During a refinancing situation, you will apply for a new mortgage loan (at the new, lower interest rate.)
- Then, when the loan closes, the money will be dispersed to your current mortgage loan servicer (Chase Bank, for example). Once paid, that loan will show the balance paid in full and will be closed.
- Then, you will have the new loan with (potentially) a new loan servicer. You'll have a new, lower interest rate and a lower monthly payment. You'll pay the new loan servicer directly each month.
In a refinance (unless you do a cash-out refinance – more on that below!) situation, you'll maintain current equity in the home, as you'll only borrow the amount you have left on your current mortgage, not for the purchase price of the home.
For example, your first mortgage loan is $100,000. Two years later, you only owe $80,000 on the mortgage. You decide to refinance to a lower interest rate. The new loan will be for $80,000, and you maintain the $20,000 equity you have in the home.
How do I find a refinance lender?
You find a refinance lender in much the same way as you found your home mortgage lender. Sometimes, if interest rates are down, your current loan servicer may reach out and ask if you want to refinance.
Remember, same as when you bought your home, you'll want quotes from at least three lenders to ensure you're getting the best – and most advantageous – rate.
Now that you know that money will be saved with a refinance, you need to gather your financial information before shopping for a loan. It's identical to how you found a lender when you first learned how to buy a house.
Here’s what you'll need handy:
- Current pay stubs
- Tax Returns (possibly for the last 3 years)
- Credit Report (free at annualcreditreport.com)
- A financial statement showing current debts and assets
It's important to have the most up to date information ready when you start shopping.
Lending Tree’s extensive loan marketplace is where national, regional, local and alternative lenders compete for your business. In just a few minutes, they can get you multiple offers on all kinds of loans, including mortgage, refinance, and cash out refinancing.
Rocket Mortgage by Quicken Loans
Rocket Mortgage is Quicken Loan’s niche site that concentrates on home loans and refinances. It gives you solutions based on your unique financial picture and integrates with your bank, so most of the information you need to get a new loan is automatically transferred into your Rocket Mortgage account.
SoFi is an alternative bank offering mortgages, student loan refinancing, personal loans, and life insurance. They only operate in certain states within the US.
As an alternative lender, they have lower refinancing fees and different underwriting techniques (as opposed to traditional banks). At Sofi, they not only look at your finances, but they also take into consideration your career experience, financial history, education, and monthly income/expenses ratios before making a decision on your refinance loan.
Why should I refinance?
There are a number of compelling reasons to refinance a home, including:
Lower monthly payments – Refinancing to a lower interest rate or longer loan term will result in lower monthly payments. And if you are paying private mortgage insurance, a refinance helps you get rid of it to reduce payments if your home has gained 20% in value since you purchased it.
Lower interest rates – Mortgage interest rates fell drastically in 2012, and 2013 rates have stayed low since. Homeowners who have high mortgage rates refinance to reduce their rates. More recently, rates in Q1 and Q2 2019 are even lower than some at the end of 2018.
To shorten the term of the current mortgage – Some people refinance to shorten the life of their existing loan, usually moving from a 30-year to a 15-year. This increases the amount owed each month, but it reduces the number of years needed to pay down the loan.
Convert from an adjustable-rate mortgage to a fixed-rate – Homeowners take loans with an adjustable rate so they can benefit from initial lower costs. However, for some owners, an adjustable rate is no longer a good option for their particular financial situation, so they refinance to move from an adjustable-rate to a fixed-rate mortgage.
Cash in on home equity – Also known as a cash-out refinance.
When Should You Refinance Your Mortgage?
Here are the top reasons to refinance your mortgage:
To get out of an Adjustable Rate Mortgage (ARM) – Adjustable-rate mortgages typically start out with lower monthly payments and increase the longer you have the loan. Most people with an ARM will refinance into a fixed-rate loan.
Take advantage of lower interest rates – If you can drop your current interest rate at least 1% or more, it pays to look into refinancing. You could save hundreds each year off your monthly payments.
Change the length of your loan – Switch from a 30-year to a 15 or 10-year loan. Maybe you’re on the path to FIRE (financial independence retire early) and you want your house paid off right around the time you plan to retire. Some people refinance into a shorter loan.
To access the equity in your home – If you have equity built up in your home, you may qualify for a cash-out refinance loan. This is where you refinance and get cash from the equity. You can use the cash to pay off debt or make home improvements. Just know that your new loan will be higher than the original, so it’s not like you’re getting free money.
Is Refinancing a Mortgage a Good Idea?
With interest rates at historically low levels, this really depends on your personal situation. Here are a few things to ask yourself to see if it’s a good idea for you:
Will you hold the new loan long enough to recoup savings – Depending on closing costs, loan terms, taxes, the rates of your new refinance loan, your break-even period may be longer than you expect to live in the house. Here’s a detailed refinance break-even calculator from Mortgageloan.com.
Switching the length of your loan too late in the game – Changing loan terms after already paying off 10 years may not make sense. You’ll increase your principal amount and lock yourself into monthly payments you may not be able to afford later.
Can you afford to refinance? – Refinancing is similar to buying a home. Take a good look at your finances. Can you afford the extra costs that go into refinancing a home? The closing costs and fees that come with getting a new loan. Make sure you’re ready.
What Credit Score Do You Need to Refinance Your Mortgage?
The reason people refinance a mortgage is to get a better interest rate and terms. Those better rates and terms are reserved for those with good credit.
For refinance, lenders normally like to see 20% equity in the home, a good credit score, and a low debt-to-income ratio (DTI). So it pays to make sure you have these things in order before you start looking to refinance.
FHA refinance loans – FHA Refinance loans have lower score requirements at 580, and depending on the type of FHA refinance loan, the requirement could go as low as 500.
Refinance programs that don’t require a credit check – If you haven’t been taking care of your credit but want to take advantage of a refinance, find out if you qualify for one of these types of refinance loans:
- FHA Streamline Refinance – You must already have an FHA loan. There is no credit check and no home appraisal.
- VA IRRRL Program – Interest Rate Reduction Refinance Loan is a federal program for existing VA loan holders to be able to reduce their interest rates or change loan types. No appraisal or credit check is needed.
- VA Cash-Out Refinance – This is a cash-out refinance loan for current (or eligible) VA-loan holders. No credit check is needed.
What Are Current Refinance Mortgage Rates?
Housing rates are influenced by the housing and bond markets, economic growth factors, inflation rates, and the Federal Reserve policies. The rate you get will be influenced by your individual situation (location, credit score, debt-to-income ratio, how much your house is worth, and how much is left on your loan).
To know what the rates are before you reach out to a lender, you can use a calculator to get an idea. Zillow has a refinance rate calculator that you can use to give you an idea based on the situation and location.
Rates will also be dependent on the type of loan you get, as well as the length of the loan you choose.
As of this writing, the interest rates for a 30yr fixed-rate mortgage refinance loan is 4.11% (APR 3.66%) – Bankrate.
When should I refinance?
Short answer: When it can SAVE you money.
Depending on your state, you can expect to pay somewhere between 1 to 5% of your new loan amount in closing costs.
Because of this, it likely won’t make sense for you to refinance your mortgage unless you are planning to continue paying it down long enough for you to recoup the closing costs.
Is it worth it to refinance?
One thing many homeowners fail to realize is that refinancing is opening a new loan. This means there will be fees and closing costs associated with the loan, even though you're keeping the same house. But, it can still be worth it to refinance if you run the numbers.
For example, let’s say a refinance will save you $100 a month in payments for the length of the new loan. If your closing cost is $5000, it will take you 50 months to recoup that money. In this example, the refinance would save you money if you plan to live in the house and pay the mortgage for at least the next 4.2 years.
If you’re not planning to stay in that house long enough to recoup the refinancing fees, then you won't save money.
It also won’t make sense to refinance your mortgage if your new interest rate isn’t at least a full point lower than your current interest rate unless you are getting some sort of closing fee credit. The closing fees will be more than what you’d save in interest.
For example, if your interest rate is at 3.7% and you only qualify for a loan at 3.5%. The 0.2% savings will not be worth it.
It's also important to keep in mind if you are three years into a 30-year mortgage and refinance to another 30-year loan, your term will start over and your payoff date will be 30 years from the date of refinancing.
Do you get money when you refinance?
Typically not, unless you are doing a cash-out refinance option. Often, many end up paying money to refinance, but the out of pocket costs are negligible compared to the interest savings. (This is why it is so, so important to run the number backward and forwards before committing to anything!)
- You will likely have to come to closing with money out of pocket in order to cover closing costs. If you can, try and find a lender with some type of incentive so you can keep yours out of pocket costs low.
- You'll also have to pay for an appraisal (again, just like when you bought the home). This is part of the underwriting process and is just for the lender to know the home will hold its value.
What should I know before I refinance my home loan?
If you can save money with a refinance, there are a few things to know before you go shopping for a new loan.
#1 – Know your credit score
An excellent credit score gets you the best interest rate and the lowest monthly payment.
For example, an excellent credit score for a $250,000 loan may fetch you a monthly payment of $898, whereas a poor credit score for the same loan can lock you into a monthly payment of $1047 a month.
Check out this mortgage rate calculator to get an idea of how much you could save with an excellent credit score.
If you have a poor score, find out what you’re doing that’s bringing down your credit score and work on getting it up as high as you can before refinancing your home loan.
#2 – Know the type of mortgage you'd like
If you already have an adjustable-rate mortgage (ARM), you can get a new loan with a fixed rate and vice versa. Know the details of each type. Here's a quick overview of the difference, in case you didn't know from buying a home before.
- A fixed-rate mortgage carries the least risk because the interest rate stays the same throughout the life of the loan.
- An ARM will fluctuate from year to year depending on the type you choose. Some ARM loans guarantee the same interest rate for 5 or 7 years, then increase or decrease every year after that based on certain indexes.
Some homeowners choose an ARM because the initial monthly payments are lower than a fixed-rate loan. However, there’s no telling what the indexes will do next year, and your interest rate may go up along with your monthly payments.
If you’re going to move into an adjustable-rate mortgage, make sure you do your homework and fully understand what your future monthly payments could look like.
The TL:DR: Most people stick with the fixed-rate mortgage because it’s less complicated than an ARM.
#3 – Ballpark your closing costs
- There’s no getting around closing costs.
- If a lender tells you there are no closing costs, it just means they’ll roll it into your new loan (that means you’ll pay the closing cost plus interest). Always ask how much you’ll pay in fees and it’s best to pay it up front.
- Your closing cost will depend on many factors and could cost around $5000-$6000 (or more depending on the loan).
- Here's an overview of average closing costs for refinancing a loan.
#4 – Double check your term (length of the loan)
Once you sign for your new loan, the length of the loan is reset, even if you’ve been paying on your old loan for 5 years.
While most people refinance to move from a 30-year to a 15-year loan, there’s nothing that says you have to do that. You can sign up for another 30-year loan if it’s the better choice for your situation and saves you money (especially if you’re going to live in the house for many more years).
Pro Tip: Also, be sure to check if your new loan has an early repayment fee. You don’t want to have that restriction on your new loan if you plan on paying it off early.
Now that wasn’t so bad, was it?
Refinancing your home mortgage isn’t scary at all now that you know what to look for.
If refinancing saves you money (and we’re all about saving money here), go for it. Just make sure you do your homework and fully understand your loan terms.