Refinancing your mortgage can save you thousands in interest over the years and lower your payment. But while you’ve probably seen commercials with mortgage lenders claiming that they’ll take care of everything, you’ll only get a “great” deal if you do your homework first.
Before applying, understand what the mortgage lender will be asking you to provide, what type of mortgage you are (and aren’t) looking for, and whether it make sense to refinance now or wait.
If you’re ready to refinance, follow these steps to get the best possible deal on your new mortgage.
5 Steps to Refinancing Your Mortgage
1. Prepare Your Financial Review
Lenders need your complete financial picture to determine whether you can afford your new mortgage payment. Before you provide this, however, it’s best to review your finances yourself.
First, review your credit report. If you find any inaccuracies, ask the credit bureaus to correct them. You don’t want material inaccuracies deteriorating your credit score or increasing the interest rate you’re offered.
Next, get your documentation together. Any bank or mortgage broker you work with will request certain items. It’s also best to review these items first, so you aren’t faced with any surprises:
- Proof of income, including tax returns, pay stubs, or bank statements
- A recent appraisal of your home (especially if you don’t have a lot of equity)
- Current credit scores and credit reports
- Property tax bills
2. Determine the Mortgage You Want
Refinancing your mortgage gives you a chance for a “do-over.” If you didn’t get what you wanted the first time, take the opportunity to tailor your new mortgage more closely to your needs.
Also, your credit score may have improved after a few years of timely mortgage payments and you may now qualify for a better rate than you did previously. But before you start shopping around, decide what you want out of your refinance.
How long of a loan term do you want?
You may want to structure your refinanced mortgage to be paid off on the same schedule as your original mortgage. For example, if you initially had a 30 year mortgage and refinanced at year six, the term of your new mortgage would be 24 years.
You can also get a longer or shorter term than you originally had. If the interest rate and fees are the same, a longer term will get you a lower payment. However, because it will take longer to pay off, you’ll ultimately pay more in interest. If you want to pay off your home quicker and pay less interest, a shorter loan term, such as 15 or 20 years, will be more appropriate, as long as you can afford the higher payments.
Do you want a mortgage with a permanently fixed rate?
An adjustable-rate mortgage, or ARM, was practically unheard of fifteen years ago. But now they are widely available and are often one of the first options a loan officer presents.
Most adjustable rate mortgages have a fixed interest rate for as little as a few months to more than five years. After this point, the interest rate will adjust according to an index of interest rates, such as the LIBOR. The advantage to an ARM is that the interest rate for the first few years is very low relative to a 30-year fixed rate. Also, these mortgages tend to be easier to qualify for.
If you’re confident you won’t stay in your home longer than the initial fixed rate period, an ARM may be a good option. But if you keep the mortgage past this point, your interest rate will likely increase and perhaps even make your payments unaffordable.
Moreover, you are at risk of the rate increasing further. In fact, many people refinancing now are getting out of ARMs and into mortgages with a permanently fixed rate. Unfortunately, this is in part because loan officers have misrepresented these loans in the past.
For example, if your loan officer tells you that the rate is fixed, ask him how long it is fixed for. Since many people ask for a “30 year fixed rate” mortgage, some unscrupulous lenders will present a 30-year loan with a fixed rate, but fail to mention that the rate is only fixed for two years. This is one reason why it’s crucial to double-check all loan documents before you sign.
What’s your home worth now?
Since home prices go up and down, you may not know how much equity you have in your home. The amount of equity is simply the amount your home is worth minus how much you owe on your mortgage and any equity lines of credit, home equity loans, or second and third mortgages.
This is important because you typically need some amount of equity to qualify to refinance. That said, even if you have little equity or are upside down on your mortgage, you may still qualify to refinance via the government supported Making Home Affordable program. Via traditional means, getting a mortgage on a home with less than 10% equity can be difficult or impossible, or you may not qualify for a low enough rate to make the refinancing costs worth it.
Are you rolling other debt into your mortgage?
In some instances, it can be smart to combine a home equity line of credit, home equity loan, or second mortgage with your primary mortgage in a refinance. This allows you to get a better rate on the debt and possibly to pay it down faster.
However, if you’re thinking of rolling high interest credit card debt into a new mortgage, carefully consider the potential consequences first. For example, what was once unsecured credit card debt and eligible to be discharged in a bankruptcy will become secured by your home. In other words, you put your home at risk if you cannot pay off the amount you rolled into your mortgage.
Also, if you’re using existing home equity to pay off any debt, you will necessarily reduce the amount of equity in your home and may be required to pay private mortgage insurance, or PMI. Because of PMI, it can sometimes cost less to keep your HELOC or credit card debt separate, even if they’re at a higher rate. PMI is generally required when you have less than 20% equity in your home and costs vary slightly by lender.
How good is your credit?
A good mortgage broker can give you a ballpark figure on which rates you’ll qualify for based on your credit score. If you can’t qualify for a lower rate, a refinane is less likely to benefit you. Make sure you know what rate you need to get on the loan term you want in order to make refinancing worth the cost.
Once you’ve answered these questions, plug the information into a mortgage calculator to estimate payments so you can better compare lender offers and identify which ones really are “too good to be true.”
Will you incur a prepayment penalty?
Since lenders profit from the interest you pay, their profit declines if you pay your mortgage off sooner than expected by refinancing or selling your home. Therefore, they’ve introduced a bit of security (for themselves) into the equation via the mortgage prepayment penalty.
A mortgage with a prepayment penalty basically charges you extra should you refinance or sell your home within the first few years of taking out the mortgage. This penalty period is often between three and five years, though may be as many as ten years or longer. Plus, the penalty charged is often steep, such as six months interest, if you pay off the loan early.
So why on earth would you want a prepayment penalty on your new loan? Well, many people don’t. But the flip-side is that it can get you a lower rate. Taking on a prepayment penalty is risky because you never know what life will throw at you and when you may need to move. That said, if you’re confident you’ll be in the same home years from now, investigate the benefit of adding a prepayment penalty to your loan and look for one that only penalizes you if you refinance and not if you sell.
3. Determine the Best Time to Refinance
If you want to refinance out of an ARM, you could miss out on potential savings if you do so before the initial low rate expires. However, there are other factors to consider as well, such as where interest rates and the housing market are headed.
For example, if you have two years left before your ARM rate adjusts, but your home equity is hovering around 20%, you may choose to refinance now so you won’t have to pay PMI if your home’s value declines. Find out from your mortgage servicer when your rates will begin to change and compare the potential risks and rewards of staying in your ARM a little longer versus refinancing now.
On the other hand, you may want to time your refinance according to other events, such as waiting until you have two years at your current job, paying down debt, or saving up money for refinancing costs. Each of these factors can make the loan qualification process easier or reduce your payment. Because applying for a refinance will hurt your credit score, it’s best to wait until you are committed before submitting your application. Otherwise, it may be harder to qualify if you stop the process and restart it, say, six months later.
Another consideration is how long you plan to stay in your home. Since refinancing usually costs between $2,000 and $4,000 depending on the size of your mortgage and where you live, make sure you’ll recoup the costs before you move. The general rule of thumb is that if you don’t plan to live in your home for at least two more years, refinancing will cost you more money than it saves.
4. Request Loan Consultations
Refinancing a mortgage is generally easier and quicker than getting your original mortgage, so there is no shortage of banks and brokers eager to help you out.
- Lending Quote Consolidators. A good place to start is with a website like Lending Tree, which allows you to get rate quotes from several different lenders. You simply fill out one form and they provide your information to multiple lenders who will compete to offer you low rates. Keep in mind though that the lowest rates and low closing costs don’t usually go hand in hand.
- Mortgage Broker or Loan Officer. You can also contact the mortgage brokers or loan officers who helped you with your original mortgage if you had a good experience with them. They can also provide information about what kind of rates you may qualify for and what the market looks like before you apply.
- Credit Union or Bank. Credit unions don’t always offer the most competitive rates, especially on larger loans like a mortgage. But if you have a longstanding relationship with your credit union or bank, you may be able to get a good deal.
Regardless of whether you decide to work with a local bank or credit union, a major bank, or a broker, your loyalty should be to your wallet. Consider offers from all sides carefully to best determine which is a good fit for you. Look at the total cost of the refinance (including origination points, discount points, title insurance, and other fees) and don’t just focus on out-of-pocket costs or your payment. Lenders have gotten very creative in making loans that are actually “high-cost” appear to be “low-cost.”
Make sure you’re comparing apples to apples when you review different quotes as well. In other words, confirm that each quote you receive is for the same type of loan – the one you requested. Unfortunately, some unscrupulous lenders will show you amazing “deals” to reel you in. Yet later, you find out that the “deal” was for an entirely different type of loan like a 6-month ARM. In fact, if you ask for a 30-year permanently fixed rate loan and the loan officer shows you a 30-year adjustable rate mortgage with a 6-month fixed period, get up and leave!
5. Out-of-Pocket Costs
You need to consider whether to pay the cost to refinance out-of-pocket or wrap it up within the loan. Though lenders will offer low or no-cost refinances, realize that many of them simply wrap the costs within the loan to be paid off later.
Examine the quotes you receive to determine how closing costs will be paid and how the terms of the loan will be affected by incorporating those costs versus paying for them out-of-pocket. Keep in mind that if you finance your closing costs, it will take you longer to recoup them. However, wrapping closing costs within the loan may allow you to refinance even when you don’t have enough cash on hand to cover costs.
The most important thing when shopping for a refinance is to come to the table prepared and double-check everything you’re told or “guaranteed.” This territory is still buyer-beware. Don’t get conned into taking the easy way out and “trusting” anyone.
You might later find, for example, that the deal you thought was too good to be true actually came with a prepayment penalty that keeps you from selling your house. Do yourself a favor and do your homework. Also, keep in mind that a mortgage is a mortgage no matter where you get it, and most will be immediately sold to another servicer after you sign.