Your Guide To What It Means To Refinance A Mortgage
When mortgage interest rates are low, you hear a lot about homeowners refinancing. Mortgage lenders advertise their great rates and borrowers are in a frenzy to get it done. So, what is refinancing? Let's walk through the process together.
What Is Mortgage Refinancing?
Refinancing allows you to pay off an existing loan by taking out another loan with better terms. Refinancing can make sense if your credit score or debt-to-income ratio have improved, or if interest rates have dropped since accepting your original loan terms.
Refinancing can help in the following ways:
- Lower monthly mortgage payments.
- Pay off credit card debt.
- Eliminate private mortgage insurance.
- Finance home improvement
- Lock in a lower interest rate.
- Shorten the term of the mortgage.
- Convert from an adjustable-rate mortgage to a fixed-rate mortgage or vice versa.
For example, Chris purchased a $100,000 home with a 30 year-fixed rate mortgage with an interest rate of 5.5%. The monthly payment is $568. After a year, Chris decides to take advantage of lower rates and refinances their home. They’re able to secure a mortgage loan with an interest rate of 4.1%, reducing their monthly payment to $477. This monthly payment difference translates into $1,092 in savings per year.
How Does Refinancing Work?
Refinancing works by replacing your existing mortgage with another one that has a different rate and term. You pay off your current mortgage with the proceeds from a new loan. You can also use a cash-out refinance to take a loan worth more than the amount that you currently owe and get the difference in cash.
The refinancing process is very similar to the initial home loan process. To refinance most mortgages, you must be named on the ownership documents and have owned the home for 6 months or more to qualify for a refinance.
Similar to your original mortgage, the higher the credit score, the better your rate. Most lenders require a minimum credit score of 620 for loan approval. If you have a median FICO® Score of 580 or better, you may be able to qualify for an FHA or VA loan with sufficiently low debt. In addition to an adequate credit score, you must have built up enough equity in your home to qualify for a refinance.
20% Equity Or More
A general rule of thumb is that you should have at least 20% equity in your home if you want to refinance. If you want to get rid of private mortgage insurance (PMI), you’ll likely need 20% equity in your home. This is also the same amount of equity you need in your home to qualify for a cash-out refinance.
Under 20% Equity
If your equity is under 20% and if you have a good credit rating, you may still be able to refinance, but your lender may charge you a higher interest rate or have you take out mortgage insurance. There are no equity requirements for interest-reduction FHA refinance loans. But you will need at least 20% equity for a cash-out refi.
A cash-out refinance is a handy way to convert your home’s equity into cash while refinancing your mortgage at the same time. In addition to lowering your interest rate, a cash-out refi can help you fund projects or consolidate debt.
Cash-out refinancing is great for borrowers who have a lot of equity in their home and they want to use that equity for immediate needs. Things like an addition, adding a garage or outbuilding, or updating home systems can add value to your home and enrich your family’s life.
A rate-and-term refinance lets homeowners change their existing loan’s mortgage rate, loan term, or both. It’s likely your financial situation has changed and you may qualify for a lower rate or your budget will allow you to pay your mortgage down more aggressively.
The goal of a rate-and-term refinance loan is to save money. You do this by getting a lower monthly payment or paying less interest overall because of a lower mortgage rate or a shorter loan term.
If you refinance into a shorter loan term, your monthly payments will be higher because you're paying off the same amount of money in a shorter amount of time. However, you do save money in the long run because you’re removing years of interest payments.
Pros And Cons Of Refinancing
Before you apply to refinance your mortgage, take a realistic look at your family’s budget. Base your decision on how much equity you have and what you plan to use the money for. Will it be worth it? Below we have some pros and cons to help you decide:
- You could refinance to a lower rate with different loan terms, saving money.
- Taking cash out of your primary mortgage means you only worry about one monthly payment.
- Your mortgage interest may be tax-deductible.
- You can potentially take out a large lump sum to pay for improvements or consolidate debt.
- You risk foreclosure on your home if you fail to make your monthly payments.
- You’ll end up paying closing costs on the entire loan amount.
- A new mortgage will mean entirely new terms, which can be good or bad.
How To Refinance A Mortgage
Remember our friend Chris? They decided to refinance their 30-year loan and take advantage of current mortgage rates. Chris reached out to their existing mortgage lender and a few others to compare pricing and discuss their options. Most lenders will require a simple online application to get approved.
Mortgage underwriters will evaluate the application in three areas: credit score, income and employment history, and assets and cash reserves. While the application is being considered, the home will need to be appraised by a licensed appraiser for its current market value. Chris will likely need to provide W-2s, pay stubs, proof of assets, bank statements, and proof of residency as they did when they originally applied for the first mortgage.
Despite the similarities between a new mortgage and refinancing, borrowers can expect less paperwork. Most refinances take less time to process than a new loan and can be clear to close in 30 days or less. If mortgage rates are really low, expect a longer wait time to close, as many other homeowners are refinancing at the same time.
The Bottom Line: Time Your Refinance Right
When you’re ready to consider refinancing your home, gather all the details about your current home budget. Factor in your family’s long term financial goals, the condition of your home, and the equity you have to make an educated decision about what's best for your family’s financial future.
If you want to read more about mortgage loan refinancing, explore special considerations for a mortgage loan refinance. If you’re ready to check out your options, you can apply online or give us a call at (888) 452-0335.