Know Your Home’s Equity
The first piece of information that you will need to review is to work out how much equity is in your home. If your house is now worth less than it was when you began your mortgage—known as being in negative equity—then it doesn’t make sense to refinance your mortgage.
Know Your Credit Score
Lenders have tightened their standards for loan approvals in recent years. Some consumers may be surprised that even with very good credit, they will not always qualify for the lowest interest rates. Typically, lenders want to see a credit score of 760 or higher to qualify for the lowest mortgage interest rates. Borrowers with lower scores may still obtain a new loan, but they may pay higher interest rates or fees.
Know Your Debt-to-Income Ratio
If you already have a mortgage loan, you may assume that you can easily get a new one. However, lenders have not only raised the bar for credit scores but also become stricter with debt-to-income (DTI) ratios. While some factors—such as having a high income, a long and stable job history, or substantial savings—may help you qualify for a loan, lenders usually want to keep the monthly housing payments under a maximum of 28% of your gross monthly income.
The Costs of Refinancing
Refinancing a home usually costs 3% to 6% of the total loan amount, but borrowers can find several ways to reduce the costs (or wrap them into the loan). If you have enough equity, you can roll the costs into your new loan (and thus increase the principal). Some lenders offer a “no-cost” refinance, which usually means that you will pay a slightly higher interest rate to cover the closing costs. Don’t forget to negotiate and shop around, because some refinancing fees can be paid by the lender or even reduced.
Rates vs. the Term
While many borrowers focus on the interest rate, it’s important to establish your goals when refinancing to determine which mortgage product meets your needs. If your goal is to reduce your monthly payments as much as possible, you will want a loan with the lowest interest rate for the longest term.
If you want to pay less interest over the length of the loan, look for the lowest interest rate at the shortest term. Borrowers who want to pay off their loan as fast as possible should look for a mortgage with the shortest term that requires payments that they can afford.
When you compare various mortgage loan offers, make sure that you look at both the interest rates and the points. Points—equal to 1% of the loan amount—are often paid to bring down the interest rate. Be sure to calculate how much you will pay in points with each loan, as these will be paid at the closing or wrapped into the principal of your new loan.
Know Your Breakeven Point
An important calculation in the decision to refinance is the breakeven point: the point at which the costs of refinancing have been covered by your monthly savings. After that point, your monthly savings are completely yours. For example, if your refinance costs you $2,000 and you are saving $100 per month over your previous loan, it will take 20 months to recoup your costs. If you intend to move or sell your home within two years, then a refinance under this scenario may not make sense
Private Mortgage Insurance
Homeowners who have less than 20% equity in their home when they refinance will be required to pay private mortgage insurance (PMI). If you are already paying PMI under your current loan, this will not make a big difference to you. However, some homeowners whose homes have decreased in value since the purchase date may discover that they will have to pay PMI for the first time if they refinance their mortgage.
The reduced payments due to a refinance may not be low enough to offset the additional cost of PMI. A lender can quickly calculate whether you will need to pay PMI and how much it will add to your housing payments.