Refinancing a Mortgage 101
What is a mortgage refinance?
A mortgage refinance is when you replace your current home loan with a new mortgage, usually to meet a specific financial goal.
Refinancing a mortgage usually takes less time than getting a new home loan, and you’re not limited to working with the same lender again. To get a refinance (called “refi” for short), you’ll generally need 20 percent equity in your home -- or a loan-to-value ratio of 80 percent. Some lenders may offer you a refinance mortgage if you a higher LTV ratio.
Once your refinance closes, the old loan is repaid in full and you’ll begin making payments on the new loan according to the terms you’ve agreed to.
A step-by-step guide on how to refinance your mortgage
- Determine your why. To make refinancing a mortgage worthwhile, ideally, you want to lower your monthly payments or interest rate without adding additional time to your loan. You want to set a clear goal for your refi that will ultimately improve your overall financial picture.
- Check your credit score and history. The higher your credit score, the better mortgage refinance rates lenders will offer you. Look for reporting errors and look for ways to boost your score.
- Find out what your home is worth. Check online home search sites to get a rough idea of your home’s value, or ask a real estate agent to run an analysis. Once you know your home’s value, you can then determine if you have enough home equity to refinance.
- Shop for the best mortgage refinance rates. Talk to at least three different lenders to see who offers you the best mortgage refi rates. Ask about what fees they charge, and if those costs are due upfront or can be rolled into your mortgage. Lenders sometimes offer “no-closing cost loans” but charge a higher interest rate or add to the loan balance. Once you choose a lender, discuss when it’s best to lock in your rate.
- Be transparent about your finances. Gather recent pay stubs, federal tax returns, bank statements and anything else your lender requests. Your credit and finances will be reviewed, too, so disclose your assets and liabilities upfront. Borrowers who have high credit score and low debt-to-income, or DTI, ratios typically receive better refi rates than those with lower scores and higher DTIs.
- Prepare for the appraisal. Some lenders may require an appraisal to determine the home’s current market value for a mortgage refinance approval. Let the lender know of any improvements or repairs you’ve done since buying your home that might add to its value.
- Know what you’ll owe at closing. The closing disclosure, as well as the loan estimate, will list cash needed to close. You might be able to finance those costs, but you’ll likely pay more for it through a higher interest rate. Store copies of your closing paperwork in a safe location and find out how to make your new mortgage payments.
Use a mortgage refinance calculator to learn how a mortgage refinance can work for you.
The best reasons to refinance your mortgage
Mortgage refinancing should help you accomplish specific goals, like lowering your monthly payments by reducing your interest rate or loan term, particularly if you bought your home when interest rates were higher. Homeowners also refinance a mortgage to pay off their homes faster, eliminate private mortgage insurance, convert loan types, or to take out cash from their built-up equity through cash-out refinancing.
A mortgage refinance means you’ll have to get approved for a new loan, have your finances and credit checked again, get a property appraisal and pay closing costs.
How to best position yourself for refinancing a mortgage
Before you get a new mortgage, here are some steps to take to put you in the best position possible to get approved.
- Strengthen your credit
Your credit score and credit history show lenders how well you manage your debts and pay your bills. The lower your credit score, the harder time you’ll have qualifying for a mortgage. You’ll also pay more in interest and might not be able to borrow as much money as you’d prefer. Take a look at your credit score to see where you stand – you should aim for the mid 700s. If your score is lacking, go to AnnualCreditReport.com to order three credit reports for free, and check for errors. Contact the rating agency immediately if you spot any.
Other good ideas: Pay off a revolving balance, and limit your credit card usage to just 20 percent of your available credit. Don’t apply for a new card before you apply for a mortgage refinance -- and don’t close existing credit lines that you’ve had for a long time.
- Reduce your debt.
A key metric lenders consider is your DTI. To get this figure, which is expressed as a percentage, a lender divides your monthly debts (including the mortgage payment) by your monthly gross income. Generally, most conventional lenders prefer to see a DTI ratio below 43 percent, although a DTI ratio of up to 50 percent is allowed in some cases.
- Know how much equity you need
Depending on your mortgage refinance goals, a loan officer or mortgage broker can give you a good idea of how much equity you’ll need for the new loan you’re refinancing into. The general rule of thumb is you need at least 20 percent equity to refinance -- or a loan-to-value ratio of 80 percent. It’s important to get a decent idea of your home’s value and calculate your equity before you refinance. With a refi, you’ll have to pay for a loan application fee and for an appraisal up front, which could be several hundred dollars.
Choosing the right refinance mortgage
Narrowing your loan choices can be difficult. Here’s a list of pros and cons of each type of mortgage. Keep in mind that individual lenders may have additional guidelines for these loan types.
- Rates and payments remain constant, despite what happens to interest rates in the market.
- Stability makes budgeting easier. People can manage their money with more certainty because their housing payments don’t change.
- Simple to understand.
- Interest payments tend to be higher for longer-term, fixed-rate loans (i.e. 30-year vs. 15-year mortgages).
- To get a lower rate, borrowers have to refinance the loan -- and pay closing costs again, as well as get an appraisal and be approved for a new mortgage.
Who should get one?
A fixed-rate mortgage is ideal if you plan to stay in your home many years and want predictable, stable payments at the same interest rate for the life of the loan.
- Feature lower rates and payments early in the loan term.
- Allow borrowers to qualify for more house because their payments are lower. Because lenders can use the lower payment when qualifying borrowers, people can buy larger homes than they otherwise could buy.
- Help borrowers save and invest more money with a lower payment, at least early in the loan.
- Rates and payments can rise significantly over the life of the loan, especially in a rising-rate environment.
- Shock of higher rates -- and payments -- when the loan resets can be hard to manage in a tight budget.
- ARMs are difficult to understand. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused or trapped by shady mortgage companies.
Who should get one?
An ARM is ideal if you don’t plan to stay in your home for more than a few years. When rates are relatively higher, ARMs make sense because their lower initial rates allow borrowers to still reap the benefits of homeownership.
- Can be used for a primary home, second home or investment property.
- Overall borrowing costs tend to be lower than other types of mortgages, even if interest rates are slightly higher.
- You can ask your lender to cancel PMI once you’ve gained 20 percent equity.
- You can pay as little as 3 percent down for loans backed by Fannie Mae or Freddie Mac.
- Minimum FICO score of 620 or higher is required.
- You must have a DTI ratio of 45 to 50 percent.
- Likely must pay PMI if your down payment is less than 20 percent of the sales price.
- Significant documentation required to verify income, assets, down payment and employment.
Who should get one?
Conventional loans are ideal for borrowers with strong credit, a stable income and employment history, and a down payment of at least 3 percent.
- Help you finance a home when you don’t qualify for a conventional loan.
- Credit requirements are more relaxed.
- Don’t require a large down payment.
- Open to repeat and first-time buyers.
- Expect to pay mandatory mortgage insurance premiums that cannot be canceled on some loans.
- Higher overall borrowing costs.
- Expect to provide more documentation, depending on the loan type, to prove eligibility.
Who should get one?
Government-insured loans are ideal if you have low cash savings, less-than-stellar credit and can’t qualify for a conventional loan. VA loans tend to offer the best terms and most flexibility compared to other loan types for military borrowers.
- You can borrow more money to buy a home in an expensive area.
- Interest rates tend to be competitive with other conventional loans.
- Down payment of at least 10 to 20 percent is needed.
- A FICO score of 700 or higher typically is required, although some lenders will accept a minimum score of 660.
- You cannot have a DTI ratio above 45 percent.
- Must show you have significant assets (10 percent of the loan amount) in cash or savings accounts.
Who should get one?
Jumbo loans make sense for more affluent buyers purchasing a high-end home. Jumbo borrowers should have good to excellent credit, high incomes and a substantial down payment.
How to find the right mortgage refinance lender
Settling on the first lender you talk to isn’t the best idea because you could be leaving thousands of dollars on the table. To find the best mortgage refinance lender, shop around. Talk to big banks, credit unions, online lenders and local independents to ensure you’re getting the best deal on rates, fees and terms. Another option: working with a mortgage broker. A broker isn’t a lender but does the legwork for you by evaluating your refinance mortgage application and then gathering quotes from multiple lenders who closely match your needs. Compare the loan offers a broker gets against those you find on your own. Look at differences in rates, fees, points, mortgage insurance and down payments — and compare your bottom-line costs.
Documents needed for a refinance mortgage
When you apply for a mortgage (a new purchase or a refinance), lenders need some documentation about your finances to make their decision. You’ll likely need to provide:
- Copy of latest mortgage statement that shows your mortgage balance
- Copy of property appraisal report from the property appraiser (the lender typically hires the appraisal company)
- Proof of income, including the previous year’s W-2 and federal tax return, as well as your most recent pay stub.
- Documentation on additional earnings, like alimony, child support or employment stock options.
- A list of all debts, including credit cards, student loans, auto loans, alimony and child support, along with balances and monthly payments.
- An inventory of your assets, including bank statements, investment records, retirement accounts, real estate and auto titles.
- Bankruptcy discharge papers, if you have had a bankruptcy within the last several years.
In some cases, you may also have to sign an IRS Form 4506-T, which allows the lender to get a transcript of your tax return from the IRS.
How to get the best mortgage refinance rates
Shop around with multiple lenders to get the best deals on refinance rates and terms. Additionally, lenders generally offer the best deals to borrowers who have higher credit scores, a positive credit history, and a lower DTI ratio.
As you shop, ideally you want to get a lower refinance mortgage rate than what you currently have, but pay attention to the annual percentage rate, or APR. The APR gives you an overall picture of your total borrowing costs, including the loan’s interest rate, lender origination fees, points and other loan charges.
These details, along with your new monthly payments, will be spelled out in the loan estimate each lender gives you. This is a three-page document lenders must provide to you within three business days of receiving your refinance application. You can use the estimate and a refinance calculator to compare loan offers and identify the best deal.
Remember to compare home refinance rates among similar loan types so you’re comparing apples to apples. Once you receive loan estimates, you can not only compare like mortgage refinance rates but also lender fees, loan terms and other details to see how offers stack up.