Mortgage interest rates are currently at historic lows. But, to take advantage of these low rates, homeowners need to take certain measures to prepare for a loan refinance. As such, we’ll use this article to outline the key steps homeowners should take when getting ready to refinance.
Specifically, we’ll discuss the following:
- Why Refinance?
- Refinance Step 1: Assess Your Credit Score
- Refinance Step 2: Determine Your Home’s Value
- Refinance Step 3: Confirm a Realistic Monthly Mortgage Payment
- Refinance Step 4: Calculate Your Debt-to-Income Ratio
- Refinance Step 5: Compare Options
- Final Thoughts
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Why Refinance?
When you refinance a home loan (a.k.a. a mortgage), you use a new loan to pay off the balance of your old home loan. After doing this, you make your monthly mortgage payments to the new lender.
But, for anyone who has gone through the hassle of closing a home loan, you know it takes a ton of time and effort. As a result, why would anyone want to go through this process a second time? While every borrower’s situation differs, the following are the four primary reasons why people choose to refinance their current home loans:
- Lower interest rate: If your current home loan has a 4.5% interest rate, and you can refinance into a 3.5% rate with a new loan, you could save a significant amount of money in interest payments over the life of the loan.
- Shorten the term: Most first-time homebuyers take out 30-year mortgages. While these tend to offer the lowest monthly payments, they also have the longest repayment periods. When borrowers pay off a large portion of their original mortgages, they often choose to refinance into shorter-term loans (e.g. 10- or 15-year mortgages). In addition to generally having lower rates, you pay these loans off faster.
- Adjustable- to fixed-rate conversion: Many borrowers select adjustable-rate mortgages (ARMs) because of a low initial rate. However, as the name suggests, these rates can jump significantly. To avoid this interest-rate risk, many borrowers choose to eventually convert their ARMs into fixed-rate mortgages.
- Take cash out: As borrowers pay down their initial loans, they build equity in their homes. A cash-out refinance lets you refinance into a larger loan than your current one, taking the difference out as cash. Common uses for this cash include consolidating debt, financing a large purchase, and dealing with financial emergencies.
While the above items demonstrate the potential benefits to refinancing your home loan, the process itself can be challenging. As a result, borrowers considering a home refinance should take the following steps to prepare for the process.
Refinance Step 1: Assess Your Credit Score
When you’re getting ready to refinance, you’ll first want to assess your credit score. This score, typically calculated with the FICO model, is based on information from your credit reports. While a variety of factors play into your score, conceptually, credit scores tell lenders about your history and payment habits when borrowing money.
So how does my credit score affect refinancing?
Put simply, credit scores tell lenders what kind of borrower you are. More precisely, these scores let lenders assess how much risk they assume when they lend you money. The lower your credit score, the more risk the lender assumes. And, the more risk the lender assumes, the higher the interest rate they’ll charge you.
Consequently, only borrowers with the highest credit scores qualify for the best mortgage rates. And, while a difference of only a half percentage point may not seem like a lot, it can add up over the life of a loan. For example, if you borrow $250,000 with a 30-year loan, a 3.5% interest rate will result in roughly $22,000 more in interest payments than a 3.0% rate loan would have over the life of the loan.
If you currently have a poor credit score, you may want to consider taking steps to improve it prior to applying for a loan refinance.
Refinance Step 2: Determine Your Home’s Value
Once you confirm your credit score, you’ll want to look at your home’s value to determine whether refinancing makes sense – or is even possible. During the actual refinance process, you’ll need to pay a professional appraiser to give you a home value. But, before refinancing, you can use free online home estimators like Zillow to give you a ballpark approximation of your home’s value.
Understandably, lenders will not lend you more money than your home is worth. And, some borrowers find themselves in the unfortunate situation of being “underwater,” which means they owe more on their current loan than their home is worth. In these situations, you won’t be able to refinance your current loan.
Furthermore, if you’re planning on conducting a cash-out refinance, knowing your home’s value will give you a good idea of how much cash you’ll pocket in a refinance. For example, let’s say that your current mortgage is $100,000, and your lender will offer you a cash-out refinance up to 75% of your home’s appraised value, that is, 75% loan-to-value. Here are two scenarios:
Scenario 1 – Lower Value
- Appraised value: $200,000
- Approved loan amount: $150,000 ($200,000 x 75%)
- Old loan amount: $100,000
- Cash out: $50,000 ($150,000 – $100,000)
Scenario 2 – Higher Value
- Appraised value: $250,000
- Approved loan amount: $187,500 ($250,000 x 75%)
- Old loan amount: $100,000
- Cash out: $87,500 ($187,500 – $100,000)
As this basic example demonstrates, a $50,000 increase in home value would mean you could withdraw an extra $37,500 ($87,500 – $50,000) in a cash-out refinance.
Refinance Step 3: Confirm a Realistic Monthly Mortgage Payment
Next, you’ll want to review your monthly budget. Just because you can refinance doesn’t mean you should refinance. In other words, while you may qualify for a shorter-term loan or a larger cash-out loan, both of these refinance options will likely increase your monthly payments.
Consequently, borrowers should confirm how much “buffer” they have in their monthly budget when it comes to mortgage payments. Let’s say that your current mortgage payment totals $1,200/mo. After looking at your monthly budget, you determine that you can afford another $300 in monthly payments for housing. This tells you that, when you look at a refinance quote, if the projected monthly payments are:
- Less than $1,500: it makes sense with your budget.
- Greater than $1,500: it does not make sense with your budget.
Doing this analysis before applying for a loan refinance gives you a quick rule of thumb for deciding whether or not a particular refinance makes sense.
Refinance Step 4: Calculate Your Debt-to-Income Ratio
In addition to credit scores, lenders will also closely examine your debt-to-income ratio (DTI) prior to approving a loan refinance.
Conceptually, DTI tells lenders what portion of your current income goes towards making debt payments. Mathematically, you calculate it by dividing all of your monthly debt payments by your gross monthly income. If you have $500 in auto debt, $200 in student loan payments, and a projected mortgage payment of $1,300, your monthly debt payments would total $2,000. With $5,000 gross monthly income, your DTI would be:
- $2,000 debt / $5,000 gross income = 40% DTI
While requirements differ by lender, most want to see a DTI of 40% or lower. This isn’t to say that a higher DTI will prevent you from getting a loan, but it’ll make the process more challenging. If possible, pay off any other debts – or boost your monthly income – to improve your DTI before applying for a loan refinance.
Refinance Step 5: Compare Options
After you’ve completed the above four steps, you’re basically ready to refinance. Now, you need to compare different refinance options. As with any large purchases, you shouldn’t take the first offer you see. Take some time to read online reviews, talk to family and friends who’ve recently refinanced their home loans, and compare different refinance options. Broadly speaking, you’ll want to compare the following between loan products:
- Loan term: Before committing to a new, 15-year mortgage, you should look at the estimates for other options (e.g. 10- and 20-year mortgages). Side-by-side comparisons help confirm – or deny – your initial assumptions.
- Annual percentage rate (APR): This is the interest percentage you’ll pay on your loan once broker fees and any points paid are factored into the rate. It provides a more accurate metric for comparison than interest rate.
- Closing costs: These are the fees that borrowers must pay during the loan closing process – not the loan itself. While not all-inclusive, common closing costs include: application fees, loan origination fees, credit report fees, appraisal fees, property and transfer taxes, and any points you pay to reduce your rate.
Once you’ve found the best loan for your unique situation, you’re ready to move forward with refinancing!
Final Thoughts
Depending on what option you choose, refinancing a home loan can save you tens of thousands of dollars in interest payments, reduce your monthly payments, and put cash into your pocket. However, successfully refinancing requires preparation. If you take the above steps, you’ll be ready to refinance when the time’s right for your situation.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
