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What to know about refinancing a mortgage

What is a mortgage refinance?

A mortgage refinance allows borrowers to pay off and replace an existing mortgage with a new loan. The reason for refinancing, also known as a “refi,” varies: It can used to lower your interest rate, reduce monthly payments or even switch your loan type. There are also cash-out refinances, which allow homeowners to refinance while withdrawing a portion of their home’s equity in cash.

Borrowers who want to refinance must apply for a new loan. Lenders consider your income, credit score, debt-to-income ratio and the amount of equity you have in your home (20 percent is typically the minimum needed to refinance a mortgage).

When should you refinance?

You may want to refinance a mortgage when interest rates fall and you can get a lower rate than you currently have.

Other times you might consider a refinance include:

1. Tapping your equity through a cash-out refinance.
2. Shortening your loan term to save money on interest payments over the life of the loan.
3. Switch mortgage types. For example, you may want to move from an adjustable-rate mortgage with variable interest rates to a more stable fixed-rate mortgage.
4. Getting rid of a loan with private mortgage insurance, or PMI. FHA borrowers, for example, are required to pay mortgage insurance premiums annually for the life of the loan, in most cases, and it cannot be canceled. Refinancing into a conventional loan, however, can eliminate this fee once you’ve attained 20 percent equity in your home.

Refinancing fees can eat into potential savings, so be sure the math works out and you plan to stay in your home long enough to break-even on those costs. To calculate your break-even point, or when you’ll start realizing those savings, add up all of the fees and closing costs then divide the sum by the monthly savings.

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.

Is it worth it to refinance?

Refinancing makes sense when you can switch to a lower interest rate, reduce your monthly payments, eliminate PMI or shorten your loan term. Ideally, refinancing should put you in a better financial position than keeping your existing mortgage, depending on your goals. Not everyone benefits from refinancing, so it’s important to assess your individual circumstances.

How does my credit score affect a mortgage refinance approval?

Your credit score is a major component lenders consider when evaluating your mortgage refinance application. Depending on the loan you want, you must meet minimum credit score requirements set by your lender. Most lenders use FICO scores, which measure credit on a 300- to 850-point scale. A score of 800 or higher is exceptional; 740 to 799 is very good; 670 to 739 is good; 580 to 669 is fair, and 579 or lower is poor. The higher you are on the scale, the more likely it is that a lender will view you as more creditworthy.

Your credit score also plays a role in the interest rates lenders will offer you to refinance a mortgage. Lenders deem borrowers with higher credit scores a lower risk, so they offer them the most competitive interest rates. If you’ve significantly improved your credit score since you took out your original mortgage, you might receive a lower interest rate today.

Is refinancing available for FHA, VA, jumbo or USDA loans?

Yes, you can refinance out of FHA, VA, jumbo and USDA loans. The same refinance rules typically apply to these loans as they do conventional mortgage refis. Borrowers will have to prove income, meet credit requirements and have a 20 percent equity position in their home to qualify for a refi.

How much are closing costs on a refinance?

Closing costs, on average, can range from between 3 and 6 percent of the total loan amount, depending on the lender. Closing costs are usually one of the larger fees in the refinancing process. For example, if you refinance and your new loan amount is $300,000, your closing costs will be between $9,000 and $18,000.

What is ‘no-cost’ refinancing?

A no-cost refinance is when a lender agrees to cover the closing costs for your new loan upfront in one of two ways: increasing your interest rate or rolling the lending fees into your loan amount. In other words, you’re not getting something for nothing. In both scenarios, you’ll end up paying more in interest than if you had paid the closing fees upfront.

Should I shop around for a refinance lender?

Yes, shop around with at least three different refinance lenders to ensure you’re getting the best rates and terms on your new loan. Keep in mind that refinance fees and timelines will vary by lender. Use Bankrate's comparison tool to see who can offer you the best deal.

How can I qualify for a refinance?

Generally, lenders require that borrowers have proof of a steady income, meet minimum credit requirements and have 20 percent equity or more in their home. Like your original home loan, lenders will review your application to make sure you can afford to repay the new mortgage.

Lenders typically reward borrowers who are deemed “low risk” with better interest rates. So, having a good financial picture will certainly help you get approved for a refi as well as snag the best rates possible.

The lender will also order an appraisal to get the current market value of your home. If you made improvements or renovated the home, be sure to inform the lender so they can consider this when determining the property’s value.

What documents do I need for a refinance?

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 should I prepare my finances to apply for a refinance?

To get the most competitive refinance rates, make sure your credit and debt-to-income ratio, or DTI, are in the best shape possible. Before applying for a refinance, pay down your debt and refrain from running up your credit accounts or opening new cards. A lender can help you identify what financial issues you may need to address to increase your chances of a successful refinance approval. There are free credit counseling services that can help guide you to improve your credit, too. A good place to start is the National Foundation for Credit Counseling and the U.S. Department of Housing and Urban Development’s list of approved housing counselors.

A step-by-step guide on how to refinance your mortgage

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.

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.

1. 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.

2. 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.

3. 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.

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.

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.