Many homeowners reach a point when they want to refinance their mortgage. In fact, from 2015 to 2016 there was a 20% increase in the level of refinancing originations in the U.S., according to the U.S. Mortgage Originations report from the Mortgage Bankers Association.
There are many reasons to refinance, but the main ones are to save money with a lower interest rate and cash out home equity. It can be a good strategic financial move, but it is important to know a few things first. To help you get a better deal on your mortgage, here are tips to keep in mind.
Know your options
First, know what the refinancing options are available. There are two main types, regular and cash-out.
- Regular refinancing.
With a regular refinance, you are simply refinancing the amount you owe to get a better deal on your mortgage. Here are a few changes you can make.
- Lower interest rate.
If you like the type of interest rate you currently have (fixed or ARM) but want to see whether you qualify for a lower rate, you can shop around to see what rate lenders will offer you.
- Adjustable rate mortgage (ARM) to a fixed rate.
If your current loan is adjustable and you want to replace it with a consistent rate that will provide predictable monthly payments, you can refinance into a fixed-interest loan.
- Fixed to an ARM.
Or vice versa, if you want to lower your payments and understand the risk with fluctuations, an ARM may provide a lower interest rate now. This can be a good option, particularly if you don’t plan on being in your home for the full length of the loan. Read more about fixed vs. ARM mortgages.
- Refinance for a shorter term.
If you want to pay off your loan more quickly and can afford higher payments, a shorter-term loan will allow you to cut down on the total interest you pay. You should also try to get a better interest rate as a shorter loan is less risky for lenders.
- Cash-out refinance.
With a cash-out refinance, you replace your current mortgage with a new loan that totals more than you currently owe on your house. It allows you to take out some of your home’s equity in a lump-sum cash payment. According to Fannie Mae’s guidelines, your loan can only account for a percentage of your home’s current market value and the maximum loan-to-value (LTV) ratio can range from 65% to 80% depending on your transaction type. So if your home is worth $200,000 and you have a maximum LTV of 80%, you could borrow up to $160,000. If you owe $120,000 on your past mortgage, you could cash out $40,000. The cash you receive can then be used as you wish, though it’s a good idea to use it for purposes with long-term benefits such as home improvements or to pay off other debt. The benefit of paying off debts such as credit cards and personal loans is that mortgage interest is tax deductible if you itemize your federal taxes, while interest on those debts is not.
Be sure to weigh all of the refinance options so you can make an educated decision on which route will best suit your needs.
Do your homework
Next, take stock of your current mortgage. What is the interest rate and what are your terms? Are there any factors about it that you like? Do you have an exit fee to pay off your mortgage early? What is it that you don’t like and want to replace? You should determine what you want in your new mortgage in terms of loan type, interest rate, monthly payment, length and total cost.
Calculate the break-even point
Refinancing can save you money on your mortgage, but it does come at a cost. Based on various lenders we reviewed, the following are common fees you may have to pay.
- Prepayment penalty.
A fee charged by the lender if you pay off your mortgage early. While restricted by the CFPB, these fees are allowed under some circumstance so be sure to check your existing mortgage.
An optional upfront cost paid to lower the interest rate, one point is equal to 1% of the total mortgage amount.
- Appraisal fees.
The amount you pay to get your home appraised.
- Escrow and title fees.
These costs include title insurance and the escrow fee. Additional costs related to the title may include courier fees and miscellaneous drawing fees.
- Lender fees.
Lenders may charge for document preparation, underwriting, processing, funding and administrative fees.
- Credit fees.
Costs to pull your credit reports from the three bureaus.
All outstanding or late property taxes will have to be paid at the closing of the mortgage.
Be sure to identify all of the costs associated with a potential loan. While a low-interest rate that results in a lower monthly payment can be attractive, it’s important to look at the whole picture. Calculate how much you will save on your monthly payment. Then, calculate how many months it will take for your savings to cover the costs of refinancing. Look for the lender that can help you break even in the shortest amount of time while saving you the most over the life of the loan.
Audit your credit report
One of the key factors in getting a good deal when refinancing your mortgage is getting approved for a low-interest rate. To do so, your credit needs to be in tip-top shape. Pull up your credit report and check your credit score. If you have any errors or negative marks you can fix, be sure to clear them up before applying. Also, calculate your debt-to-income ratio (total monthly payments toward debt/gross monthly income) and ensure it is 43% or lower, as it will play a role in getting approved, as per the Consumer Financial Protection Bureau (CFPB).
Shop around for the best overall deal
Once you know what you want and how to identify a good deal, it’s time to shop around. You have many lenders from which to choose so it will take some vetting to find the best ones. Here’s a quick list of what to look for.
- A lender offering the loan type you want
- A low-interest rate
- Low fees and penalties
- Service (good customer service and positive reviews from past customers)
Once you have a shortlist of lenders, apply. According to the Consumer Financial Protection Bureau, lenders must provide you with a standard three-page loan estimate within three business days of receiving your application. This estimate will include your estimated interest rate, closing costs, monthly payment, tax and insurance costs, penalties, features and how your interest rate and payments may change in the future.
All lenders will use the same standard form, which makes it easy to compare the offers. Obtaining this form doesn’t mean you are approved or denied for the loan, it just shows what each lender is offering so you can choose the one with which you want to move forward.
Consider a rate lock
Lastly, you may want to get a rate lock if interest rates drop and you have found a lender that offers a good overall deal. A rate lock is when you lock in an interest rate and cost structure with a specific lender. In doing so, the lender is obliged to give you that rate on your loan, regardless of whether the rates have changed from the time of the rate lock to the closing date. Rate lock periods typically range from 30 to 65 days or more, the Consumer Federal Protection Bureau says.
Note that the safest time to get a rate lock is after your appraisal. The interest rate you are given depends on your home’s valuation and loan-to-value ratio. If you get the rate lock before your appraisal and the numbers you originally submitted end up being inaccurate, the interest rate will have to change. Also, ask whether a rate lock carries an additional cost. A lender may charge you a small increase in interest, so make sure the cost doesn’t outweigh the benefit.
For a lender to lock in your rate, you will first need to apply with it and get prequalified.
Find the best lender for you
Refinancing your mortgage can be a great financial move. If you think it’s the right one for you, be sure to educate yourself on the refinance options, do your homework so you fully understand the terms of your current loan and what you want, calculate the break-even point, audit your credit report, shop around and consider a rate lock.
When it comes to choosing a lender, it will take time to research your options. However, you can find a wide range of lenders in one convenient location on our home loans review page. You can easily compare offerings and read feedback from past customers.
Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.