High interest rates have made refinancing unattractive for most homeowners.
Current mortgage rates are much higher than they were during the height of the pandemic, making a rate and term refinance impractical for most homeowners who already locked in low mortgage rates. Still, there are still some circumstances in which a refi is the right choice.
As home values rose, homeowners gained a large amount of equity in recent years. A cash-out refi provides access to that equity and could make it easier for the homeowner to pay down higher-interest debt or cover unexpected expenses. There are, however, other options for accessing home equity, such as home equity loans and home equity lines of credit, so make sure to see what works best for you.
A refi, even at today's higher rates, may also make sense for homeowners coming to the end of the fixed-rate period on an adjustable-rate loan. Switching to a fixed-rate loan can lock in a steady rate and avoid periodic increases in the monthly payment.
If a refinance sounds like the right move for you now but you aren't sure where to start, following these steps can set you on the right path.
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 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 and credit report
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 until December 31, 2023. (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
You 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 refinance lenders to see which one offers the best package for your needs. (Money's list of the best mortgage refinance lenders is a good place to start.)
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 your current lender 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.