How to Refinance Your Mortgage (and Lower Your Monthly Payments)
You may have heard that now is the perfect time to refinance your home loan. This is true for many homeowners who might be able to lock in lower rates and save thousands in interest on their mortgages.
If you’re considering refinancing your home loan, but not sure what refinancing means and how to get started, I’ll walk you through everything you need to know.
What does it mean to refinance your mortgage?
When you refinance your mortgage, it simply means that you replace your existing home loan with a new one. This might not seem beneficial at first, but if you’re able to replace your current mortgage loan with a new, lower-rate loan, you might end up saving money on your home.
Many homeowners consider refinancing if they’re looking to reduce monthly mortgage payments or save money on interest over time. Other homeowners who find themselves in need of a large amount of capital quickly might be looking to tap into their home’s equity.
How does refinancing work?
The money you borrowed for your initial mortgage was paid to the original home seller. With a mortgage refinance, this money is actually used to pay off your existing mortgage, instead. This way, you’ll be left with only one home loan — the new refinancing loan.
All home loans require borrowers to get approved based on certain criteria and refinancing loans are no different. While qualifications might vary from lender, the below is typically required to get approved for a refinancing loan:
- Good credit score (620 or higher)
- 20% equity (or more) in your home
- Low debt-to-income (DTI) ratio (43% or lower)
Again, some mortgage companies might still approve you for a refinancing home loan if you’re just shy of meeting the above criteria, but these are general expectations that you should be aware of when starting the refinancing process.
Refinancing loan terms
One of the most important factors to consider when refinancing your mortgage is your loan term. If you took out a 30-year mortgage, you might be tempted to take out another 30-year mortgage when you refinance. However, it’s important to be aware that doing this will extend the period of time you’re paying on your loan, which could lead to paying more in interest over time. However, those looking to simply lower their monthly payments might prefer paying more in smaller amounts over a longer period of time.
If you don’t want to pay more over the long-run or extend your mortgage term, consider asking your lender to meet your remaining mortgage term. For instance, if you decide to refinance 4 years into a 30-year mortgage, you can ask your lender to distribute your payments over 26 years, rather than 30.
You might also consider mortgage refinancing to reduce your loan from a 30-year mortgage to a 15-year mortgage. While this might lead to a higher monthly payment (even with lower refinance rates), you’ll ultimately end up paying less over the lifetime of your mortgage.
Steps to refinance your home loan
1. Establish your financial goal
Before you start shopping around for refinancing loans, it’s important to be clear about the financial goal you’re setting. If you’re hoping to save money on monthly payments, identify how much you want or need to save, and keep this figure in mind as you navigate through the process.
If your goal is to save thousands in interest payments over the lifetime of your new refinance loan, be sure to compare your current mortgage rate with new rates as you begin sifting through mortgage options. You’ll want to calculate your savings in order to decide if refinancing is still the right choice for you.
Lastly, if your financial goal is to obtain home equity to pay for construction expenses or other high-dollar bills, make sure you identify the bottom-line number you need to secure to make refinancing a worthwhile option. Make sure you take into account your new mortgage payment, which will likely be higher than your current monthly payment.
2. Review your credit score and mortgage qualifications
I always recommend preparing for your mortgage screening up-front, that way you can set a realistic timeline for applying.
Assess your credit report
First, review your credit score by obtaining a free credit report from any of the three credit bureaus (Experian, Transunion, or Equifax) or by utilizing a free service like CreditKarma. Once you have your report, check your score and any negative marks on your accounts. If your score is above 620, you’re more likely to get approved for a refinancing loan. However, I recommend reviewing any negative marks on your report and working to boost your credit before applying. You may be able to lock in a lower rate by doing so.
Determine your DTI ratio
Next, you’ll want to check your debt-to-income ratio or DTI. This number allows lenders and banks to decide if you’re likely to be able to make on-time mortgage payments. To calculate your DTI, you’ll first need to know your monthly income (before taxes) and your total monthly debt payments (mortgage, credit cards, loans). Divide your monthly debts by your pretax monthly income. Then, multiply this number by 100. This is your DTI percentage.
For instance, let’s say your monthly debts are $2,000 and your monthly pre-tax income is $7,500. Your formula will look like this:
$2,000 / $7,500 = .267
.267 x 100 = 26.7%
Lenders typically look for a DTI percentage that’s under 43%. If yours is much higher, consider paying off credit card debt or other loans before applying to refinance.
Review your home equity
Lastly, you’ll want to make sure you have at least 20% home equity in your home before refinancing. If you’re very close to this number, lenders might approve you, but 20% is the general minimum.
If you made a downpayment of 20% on your home at the time of purchase, you’re all set. If you did not, you’ll need to calculate your equity. A simple way to do this is by subtracting your current loan balance from your home’s estimated value. This will give you your home equity amount. Then, divide this amount by the value of your home to find your equity percentage.
For example, if your mortgage balance is $200,000 and your home’s value is $275,000, you’ll have $75,000 in equity. Take $75,000 and divide it by $275,000 to get your home equity percentage of 27.2%.
If you have less than 20% equity in your home, you can review your monthly payments to decide when you’ll reach this number. If you can wait, your chances of being approved are much greater.
3. Compare mortgage lenders
Once you’ve determined you meet the general criteria to refinance your home loan, it’s time to shop around for lenders. If you’ve had an excellent experience with your current lender, I recommend reaching out and finding out about their current rates, discounts, and offers.
However, even if you do love your current home loan provider, you should always shop around. Be sure to compare online lenders who typically have lower rates and also call local banks and credit unions in your area to discuss your options.
Be sure to also review or ask about refinancing criteria, since some lenders have stricter requirements than the general guidelines.
Narrow your list down to 3 to 5 lenders before moving on to step three.
4. Apply with multiple lenders
It might seem time-consuming to apply for a new home loan with multiple lenders, but doing so can help you identify that new home loan that best fits the financial goal you identified in step 1. I’d recommend applying with 3-5 lenders, then comparing the rate and terms offered to figure out if you’ll save on your monthly payments or in the long run (or both!).
You should apply with multiple lenders within the same week (applying a few days apart is ideal), in order to ensure your credit report takes less of a hit from multiple hard inquiries. Applying with multiple lenders will also give you more options to choose from, particularly if you just meet one lender’s criteria and you’re not sure you’ll be approved after the underwriting process.
Lastly, if you’re looking to access your home’s equity and applying for a refinancing loan to do this, it’s even more important to compare lender’s rates, terms, and fees. Since home equity refinancing loans require taking out a loan above the home’s value, you’ll want to clearly understand the financial implications of this contract.
5. Choose a lender
Once you’ve been approved by more than one lender, compare your new mortgage rates and terms to decide which option best fits your financial needs. Make sure to consider the loan estimate document your lender provides when comparing your option. This document will also detail how much money you’ll need to provide up-front at the time of closing. Even if one loan has better rates, it could require you to pay more at closing than you’re able to.
During this process, make sure you decide if the rate you were approved for is lower enough to justify refinancing. If you’re approved for a mortgage at 3.5%, but your current mortgage is at 4%, it may not save you as much money as you expected. Be sure to also pay attention to whether you’re approved for an adjustable-rate mortgage or fixed-rate mortgage, as this will determine how much you end up paying in interest.
6. Lock-in your interest rate
After choosing your lender, it’s always a good idea to try to lock-in your interest rate. Since loan rates fluctuate daily, it can be smart to seal in your rate as quickly as possible. Once you lock in your home loan’s interest rate, it will be guaranteed for a set period of time.
It’s important to work with your lender to close on your home before your rate-lock expires, or you could end up committing to a higher interest rate.
7. Prepare for the home appraisal
Most refinancing loans require a home appraisal, though some lenders might skip this step. Appraisals will determine how much your home is worth, which can impact your home loan amount. Lenders won’t agree to lend you more than your home’s value, so you’ll want your appraisal to come in high.
Here are some tips for boosting your chances of receiving a higher home appraisal:
- Make sure everything is in working condition - Test lights, outlets, thermostats, and other systems to ensure they work well. If they don’t, be sure to make the necessary home improvements needed prior to your appraisal.
- Reduce clutter - Too much clutter can make it hard for an appraiser to accurately assess your home’s condition. Reducing clutter makes your home appear cleaner and better cared for, which can also boost your appraisal number.
- Invest in small upgrades - You don’t want to start a full renovation project before an appraisal, but small upgrades can boost your home’s value. Updating cabinet hardware, installing eco-friendly and modern light fixtures, and updating your appliances are some ideas to consider.
- Don’t forget about the outside - Improve your home’s curb appeal with attractive landscaping and a quick clean. Powerwash your home’s siding and clean windows prior to your appraisal.
- Assess similar property values - Lastly, be sure to research comparable homes on your block or nearby streets and review their current home values. Search for properties similar to yours in terms of square footage, the number of bedrooms and bathrooms, and floorplan. Have this information ready in case the appraisal comes in lower than expected.
8. Close on your new loan
If your appraisal comes back without any issues, it’s time to prepare to close on your new mortgage. Just like the first closing, you’ll want to ensure you have all documents and costs (like origination fees and agent expenses) required ready prior to your closing. Not being prepared can lead to delays, which could impact your mortgage rate.
Pros and Cons of Refinancing
Pros
Lower monthly payments
If you’re struggling to afford your mortgage and need a lower payment, refinancing may help you lower your monthly payment. Since mortgage interest rates are currently at historic lows, it could be possible to lock in new terms that can save you money each month.
Save more over time
If your financial goal is to save on interest costs long term, you can try to refinance from a 30-year loan to a 15-year loan. You might end up paying more each month, but you’ll ultimately save thousands of dollars in interest down the road, and pay off your home loan sooner.
Access to home equity
You might be refinancing to secure access to your home’s equity. Taking out a cash-out refinance loan is one way to receive access to these funds if you need a large amount of capital right away.
Eliminate PMI
If you didn’t pay 20% down on your home, you’re likely paying private mortgage insurance or PMI. While most lenders eliminate the need for PMI once you reach 20% equity on your home, this isn’t always the case. If your first mortgage was a conventional loan and you have lender-paid mortgage insurance or if you took out an FHA loan and pay a mortgage insurance premium (MIP), you’ll pay this for the duration of the loan. However, refinancing once you’ve reached or exceeded 20% equity can remove this mortgage insurance requirement.
Cons
More expensive long-term costs
The downside to lower monthly payments is that in order to secure them, you typically have to extend your loan term. If you had 25 years left on your first mortgage and refinance with a 30-year loan, you’re adding on another 5 years of payments. This means that while you’re spending less each month, you’ll ultimately end up paying more down the line.
Out-of-pocket closing costs
Of course, in order to secure a refinancing loan, you’ll need to factor in closing costs. If you’re refinancing to reduce your monthly payment and do not have much money in savings, refinancing might be an additional expense you can’t afford. Ultimately, you’ll have to repay closing costs in order to refinance your home loan — there really is no way around this step.
Extended break-even period
Lastly, you should consider how long it will take you to recover the closing costs you’re providing before refinancing. In order to figure out your break-even period, you’ll first need to add up your closing costs and also determine how much money you’re saving each month on your new loan. If your closing costs are $5,000 and your monthly savings amount is $80, you’ll divide $5,000 by $80 and get 62.5. This is how many months it will take you to recoup your closing costs.
The bottom line
With mortgage rates at an all-time low, many homeowners are turning to refinance options to try to lock in new interest rates. If you’re considering refinancing, I recommend reviewing your financial goals first, then making sure your meet lender requirements. If you still think refinancing is right for your financial situation, be sure to weigh the pros and cons, review lenders, and lock-in your rate to improve your chances of a successful refinancing process.