As mortgage rates remain low, refinancing your mortgage can be a good way to reduce your monthly expenses or accelerate your savings.
With current rates near the all-time low, refinancing your home loan now can help you save thousands over the course of a year and tens of thousands over the life of the loan. Homeowners who refinanced in 2020, their mortgage saved an average of $2,800 per year, according to Freddie Mac.
There are more than 15 million qualified homeowners who could benefit from a mortgage refinance, according to data analytics company Black Knight. Even if you ultimately decide not to refinance, it is worth looking into to see if it makes financial sense.
With rates constantly change, the sooner you take steps to prepare yourself the better off you'll be. Going over your finances, improving your credit score and shopping around for a mortgage lender can help you find the best rates.
Once you apply, remember it takes time for the loan to go through. The average refinance loan took 48 days to close in June, according to ICE Mortgage Technologies.
These steps will help you get a jump on the refi process.
1. Set a refinancing goal
Most homeowners refinance in order to get a lower interest rate and, as a result, reduce their monthly payments. However, that’s not the only reason to refinance.
Different loan types offer different advantages.
You may want to switch from an adjustable-rate mortgage to a fixed-rate mortgage to guarantee a permanently lower rate. Maybe you want to switch from a 30-year loan to a 15-year loan to pay off your mortgage faster. If you have enough equity, you may also be able to save on mortgage insurance by switching from an FHA loan to a conventional mortgage.
Perhaps you've recently run up against major medical bills, unexpected home repairs or other expenses that are weighing you down financially. If you’ve built up enough equity in your home, a cash-out refi will not only let you refinance your loan but also take out extra cash.
Knowing what you want to accomplish with a refi will help you determine the type of mortgage product you need. Consider all the options to see which works best for you.
2. Check your home equity
You may be able to qualify for a conventional refi loan with as little as 5% equity in your home, according to Discover Home Loans. However, most lenders prefer you have at least 20% equity.
If you have more home equity, you may qualify for a lower interest rate and lower fees, as lenders will view borrowers who have higher equity as less of a lending risk. More equity also means that you are less likely to end up owing more than the home is worth if home prices fall.
To get an estimate of your home equity, subtract your current mortgage loan balance from your home’s current market value. The result will be your home equity. Contact a knowledgeable local real estate agent to get an idea of your home’s value. Zillow’s home price estimate can also be a good rough starting point too.
You should also prepare your home for an official appraisal, which will be part of the refinance application process. Have documentation about any improvements you have made to the home handy. (For example, did you add a bathroom or replace an old roof?) It won’t hurt to clean and organize your home to get it in showing condition.
3. Check your credit score
Before making any loan decisions, it’s important to check your credit score, as well as your credit report.
Your credit score will in large part determine how favorable a rate a lender will offer. The higher your score, the lower the rate you’ll qualify for and the lower your monthly payments will be. If you have a low score, look for ways to improve your credit score well before applying for a loan.
Your credit report shows the information your score is based upon. It’s where you can check if there are any errors that may be negatively affecting your credit score. If you find mistakes in your report, you can contact the credit bureaus to have these items removed. Be prepared to provide documentation proving the mistake.
As part of the consumer protections put in place by the CARES Act, you can get a free weekly credit report from any of the major reporting bureaus through April 2022. (Typically, you're entitled to one free report from each credit reporting company per year.)
You should also be aware of what factors could cause a temporary hit to your credit score. Applying for credit cards, personal or auto loans just before, at the same time, or just after applying for a refi will lower your score, albeit temporarily.
4. Do the math to see if refinancing will pay off
Before applying for a refi, make sure you understand the costs associated with a new loan. Refinance closing costs typically run between 2% and 5% of the total loan amount. For a refi to make sense, you have to be able to recover these closing costs, as well as save money over the long term.
To determine if it’s worthwhile, you’ll need to calculate your break-even point. This refers to how long it will take for the savings from the new loan to surpass its cost. You can calculate the break-even point by dividing the closing costs of the loan by the amount of money you save every month.
For example, if your closing costs are $5,000 and your monthly savings are $100, your break-even point would be 50 months or about four years. In this case, refinancing probably makes sense if you plan on living in your home longer than four years.
An easy way of figuring out if a refi is right for you is using a mortgage refinance calculator.
5. Get your mortgage paperwork in order
Even with recent advances in the online application process, you're still going to need a lot of documentation that proves your financial readiness to refinance.
The documents you should have handy include your latest pay stubs, the last two years of W-2s, information about your current home loan, as well as information on property taxes and home insurance.
If you’re self-employed or have a non-traditional job, have two years of bank statements available. You may also need a profit and loss statement from your bank, the last two years of 1099 forms and client invoices as proof of income.
A lender may have additional documentation requirements depending on their initial assessment of your finances. Once you have decided on a lender, find out about any other requirements so you can get it together ahead of time. Doing so will make the application process a lot smoother.
6. Shop around for a mortgage lender
Don't just take the first interest rate you're offered. You should compare rates and terms from at least three different lenders to see which one offers the best package for your needs.
You should also consider different types of lenders. Compare rates from big banks as well as online lenders and local credit unions. If you have a long-standing relationship with a financial institution that also offers home refinancing, check with them as well. You may be able to negotiate a better rate if you already have other financial dealings with the lender — but not always. Don't assume the lender you know is giving you the best deal.
7. Lock in your rate
Once you’ve found a lender that offers the terms and rate that best suit you, lock in your interest rate. A rate lock will ideally guarantee that your interest rate won’t increase before closing.
However, rate locks are typically made for 15-to-60 day periods. With lenders taking a while to close these days, you may want to opt for a longer lock. While some lenders may not charge for a rate lock, others will. Rate lock fees can vary between 0.25% to 0.50% of the total loan amount. If your loan doesn’t close in time, extending the lock period can lead to additional fees.
The key with a rate lock is timing. Consult your lender to find out how long they typically take to close, then lock the rate for that amount of time.
A note about mortgage forbearance.
If you’re struggling to make your mortgage payments as a result of the COVID-19 pandemic, seeing if you qualify for a loan refinance can be a good first step.
Refinancing your loan could bring your mortgage payments within your budget. However, if refinancing isn’t an option because you don’t have enough income or your credit score has taken a hit, then consider requesting forbearance from your lender.
Forbearance allows homeowners to pause their mortgage payments for an initial six-month period. If conditions do not improve within that time frame, up to two six-month extensions can be requested. The deadline to request forbearance has been extended several times, with the latest extension ending on September 30th.
The paused payments do not go on your credit report as late payments, and forbearance doesn’t negatively affect your credit score, but the fact that you requested a pause in your payments does go on your credit report. Potential lenders can see this information and that can affect your desirability as a borrower.