A home mortgage refinance may sound like a good idea in theory, but it’s not always possible or desirable.
For starters, lenders have tightened up the approval process, making it more difficult to get a loan.
“Homeowners today need to be triathletes to qualify for a loan, with great income, great credit and great value in their home,” says Anthony Hsieh, founder and CEO of loanDepot.com, headquartered in Irvine, Calif.
In addition, a refinance may not make sense financially, particularly for borrowers who plan to sell their homes in the next few years.
Before taking the leap and opting to refinance, homeowners should ask themselves the following six questions.
Do I have equity in my home?
Homeowners need to have at least 20 percent equity in their home to qualify for a new loan without paying private mortgage insurance. Adding PMI to the cost of a new loan could negate the benefit of a refinance.
Today, many homeowners are underwater — meaning they owe more on their mortgages than the house is worth. However, being underwater or having little equity does not necessarily rule out a refi.
“Homeowners should still apply for a refinance even if they have low equity, because there are some Fannie Mae and Freddie Mac programs and FHA loans that may accept them,” Hsieh says. “The best way to find out if you fit into a program is to go to a lender.”
Roy Meshel, district vice president for W.J. Bradley Mortgage in Phoenix, recommends homeowners refinance quickly in case the housing slump deepens, causing values to depreciate even more.
Patrick Cunningham, vice president of Home Savings & Trust Mortgage based in Fairfax, Va., recommends an increasingly popular approach — the so-called “cash-in” refinance.
“Some people are opting to bring cash to the settlement in order to pay down their loan balance to qualify for a refinance,” he says.
Do I have good enough credit?
Borrower credit scores play a big role in securing a good mortgage rate. In fact, you’ll need a good credit score to qualify for any type of mortgage at all.
Mortgage rates operate on a sliding scale, with the lowest rates going to applicants with the highest credit scores of 720 or higher.
Borrowers with scores below 620 will have trouble qualifying for a mortgage at any rate.
What are my financial goals?
Many homeowners refinance to lower their monthly payments. A mortgage calculator can give borrowers a sense of what their new payment would be after a refi.
Others choose a shorter-term loan with higher monthly payments so they can reduce overall interest payments and own their homes faster.
“Some people are restructuring their loans to a 20-, 15- or 10-year mortgage, which works well for people with plenty of disposable income,” Cunningham says. “But I worry that people are too focused on paying off their mortgage and not integrating this decision with their overall financial plan.”
Cunningham urges borrowers to make sure they contribute to retirement savings and college savings, pay off high-interest debt, and save six to 12 months’ of expenses “before opting for a shorter, more expensive mortgage.”
Meshel says people should consider whether they want to retire without a mortgage before opting for a new 30-year loan. Those who have employment concerns may want to refinance into the lowest possible payment in case they experience a job loss.
How long do I plan to stay in this home?
Mortgage professionals generally tell borrowers to expect a home refinance to cost 3 percent to 6 percent of the loan amount. A simple calculation shows how long it will take to reach the break-even point when the savings outweigh the costs.
“If the break-even is at 15 months and you plan to stay in the home for five years or longer, it is probably worth it to refinance,” Cunningham says. “But if you plan to move in two years, it may not make sense.”
Meshel says long-term homeowners who are close to paying off their mortgages might not want to refinance because of the costs incurred.
What are the terms of my current loan?
Borrowers with adjustable-rate mortgages or interest-only loans should consider the potential benefit of switching to a fixed-rate loan. Hsieh says all borrowers with ARMs should switch to a fixed-rate loan unless they intend to move within one year.
However, Cunningham says some borrowers can benefit by sticking with their current ARM.
“Consumers with a subprime ARM should definitely switch to a new loan,” Cunningham says. “But some with conventional ARMs may find that they are in a good loan and that their rates are actually dropping.”
While new loans today rarely have a prepayment penalty, many homeowners still have loans with that restriction, which could reduce the financial gain of a refinance, Meshel says.
Do I have a second mortgage or line of credit?
Cunningham says borrowers with a second mortgage will face additional complexity when refinancing.
“Borrowers can either pay off the second loan or combine the two loans into a larger first mortgage,” Cunningham says. “Otherwise, the lender holding that second loan must agree to stay in second position behind the lender of the first mortgage, which the lender may or may not be willing to do.”