A Checklist for Refinancing Your Mortgage

Many people are refinancing their homes now while mortgage rates remain near record lows. If you’ve decided to look into the process, then there are several pieces of information you should gather before you actually move forward. It’s best to have everything at your fingertips before you start working with a loan officer or broker.

Why do you want to refinance?

Before you even start thinking about moving forward with refinancing your home, you should make sure that your reasons for doing it are sound. Right now the most common reason for refinancing a home is to get a lower interest rate than the rate that was secured when the mortgage was originally taken out.

Interest rates have come down, so many people can save quite a bit of money on interest by refinancing. However, that’s not the only reason people refinance their homes. Some want to reduce their monthly payments, which is possible by taking a 15- or 20-year mortgage and refinancing it into a 30-year loan. If possible, it is best not to extend the term unless absolutely necessary to make the loan affordable on a monthly basis.

Others can afford a higher payment, so they may want to refinance for a shorter term instead, which saves a lot of money on interest. Still, others want to tap into their home’s equity, so they take a cash-out refinance to get some money back and put it toward home repair or renovation products or other debt with higher interest rates.

Another reason to refinance a mortgage is to get rid of FHA mortgage insurance. This insurance is expensive, and it raises the monthly payments on the loan. If you don’t have at least 20% of the purchase price to use as a down payment when buying a home, you must pay FHA mortgage insurance if you take out an FHA loan instead of a conventional loan.

You may also want to refinance to switch from an adjustable-rate mortgage to a fixed-rate mortgage. This especially makes sense right now while rates are low because it will protect you when interest rates increase eventually.

Home equity

One of the most important pieces of information to gather before you refinance is the amount of equity you have in your home. Equity is the percentage of your home that you own free and clear. You may need an appraisal to determine what your home is worth. Some homes increase in value during the life of the mortgage, while others decrease, and still, others hold fairly steady.

Most conventional lenders require that you have a decent amount of equity in your home before you can refinance. If you are doing a cash-out refinance, most lenders won’t loan you more than 80% or 90% of your equity. If you aren’t doing a cash-out refinance, you will need to have at least 20% equity in your home to be able to refinance without any problems.

Credit rating and debt-to-income ratio

Many people who already have a mortgage automatically assume they will be able to refinance, but that may not be the case. Those who have seen their credit rating drop might not be able to get a new mortgage as many lenders have raised the bar for credit scores.

This also means that even though your credit score was good enough for a low interest rate before, you might not qualify for the lowest rate now. For some borrowers who are trying to refinance for a lower interest rate, it might not make sense to refinance if they can’t get the lowest rate possible. To get the lowest possible interest rate, you will probably need a credit score of at least 760.

You also need to know your debt-to-income ratio. Lender standards for this measure have also been tightened in recent years. Most lenders want to keep mortgage payments at no more than 28% of the borrower’s gross monthly income. The overall debt-to-income ratio should be no higher than 36%, although in certain cases, lenders may be willing to increase this to 43%. If you have a lot of debt, you should pay some of it off before refinancing.

Interest rate

If you’ve been thinking about refinancing because interest rates are lower, you must first know at what point it makes sense to refinance for a lower rate. If you’re refinancing to get a lower interest rate, then you will want to secure a late that’s at least 1 percentage point lower than the rate you have now so the savings will be large enough to make a difference in the size of the payments.

Beyond that, you’ll have to do the math to determine whether it’s actually worthwhile to refinance for a lower rate. Some borrowers find that their credit score increased since they took out their mortgage, so that can also help you get a lower interest rate.

As you shop around for interest rates, keep in mind that some lower-quality lenders may offer lower interest rates. You must ask yourself what you are willing to put up with to get that lower interest rate. For example, some lenders repeatedly hound you to refinance, starting within a month or two of taking out the loan in the first place. They don’t care about actually helping you get a better deal. They just want to rake in money on closing costs.

Other lenders repeatedly have to recalculate your monthly payments because they are constantly getting your tax and insurance amounts wrong with your escrow account. You may even find your monthly payments suddenly increase $100 per month because of how poorly managed your escrow account was.

Breakeven point

It’s also important to know where your breakeven point stands. To do this, you will have to keep the interest rate, points and closing costs in mind, especially if you plan to roll those costs into the loan. Points amount to 1% of the loan amount and are generally paid for a lower interest rate. When it comes to breaking even, you need to know how much in fees and extra costs you are incurring to refinance and get the lower interest rate or to meet whatever your goal is in refinancing.

For example, if you’re paying $3,000 to refinance the loan, and you’re saving $100 a month, it will take 30 months to break even on the refinance. If you’re planning to move before that time, it doesn’t make sense to refinance because you’re just going to cost yourself more in closing costs than the savings you will get from refinancing.

When you have these numbers ready to go, you’ll be able to quickly see whether it makes sense to refinance based on how much money you can save. Some lenders are just in business to make money on closing costs, so they aren’t interested in advising you on whether you can actually save money by refinancing.

Thus, it’s important to have all of your information ready to go so you can do the math and make sure that refinancing is the right thing to do.