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If you own your home, you've probably heard about refinancing your mortgage, but you may not know why it’s important. The biggest advantage to doing so is a lower interest rate, which means a lower payment and money saved each month—here's how to refinance.
We all look for ways to save on our monthly expenses. Refinancing your mortgage can help you accomplish that by reducing your interest rate and, thus, your monthly payment.
However, even though you already have a mortgage and may well have all sorts of pre-approval offers, that doesn't mean the process is as simple as filling out a few forms.
The refinancing process is virtually identical to that of applying for a mortgage in the first place. If you haven't applied for a mortgage recently, you might not remember everything you had to do, so we've put together seven steps for how to refinance your mortgage.
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How Does Refinancing Work?
Refinancing doesn't involve just changing the terms on your current real estate loan. You're taking out an entirely new loan that replaces your current mortgage.
Most people take out mortgages when they buy homes because they don't have the cash to pay for them. That money goes to the seller and possibly also to things like commissions and closing costs.
When you refinance, the money from the new loan goes to the bank to pay off your current mortgage. Your new loan has a lower principal amount and a lower interest rate, too, ideally.
Since you're getting a new mortgage, you have to apply, go through the qualifying and underwriting processes, and then close on it, pretty much as you did when you got your first mortgage.
Why & When You Should Refinance
If you're getting an entirely new loan, aren't you also extending the amount of time over which you owe money?
With a home refinance, it depends. If you're replacing a 30-year mortgage with a new 30-year mortgage, then yes. However, many people refinance their mortgages to 15-year loans and ultimately reduce the amount of time they're in debt to the bank.
Most people refinance to get a lower interest rate and, thus, a lower monthly payment. Depending on how low you can go on the interest, you can take hundreds off your mortgage payment.
That often means more to people than how long they'll be paying on their loan.
Others refinance because they can qualify for a fixed-rate mortgage and get out of the unpredictability of an adjustable-rate loan.
Some people borrow more than they owe to gain access to the equity they have in their home when they refinance. This is known as a cash-out refinance, and you can usually get the lower interest rate and the cash at the same time.
You can tap into your home's equity with a home-equity line of credit, but if you'd rather not open a new credit line, a cash-out refinance is an attractive option.
7 Simple Steps to Refinance Your Mortgage
With all of that in mind, here are the seven steps we've identified that will help you through the refinance process, making it as easy as possible.
1. Set a goal. Think about why you want to refinance. Is it to lower your monthly payment and possibly get rid of your mortgage insurance?
Maybe you just want to shorten the term of your loan even if it means higher monthly payments, or perhaps you're looking for money for a major home improvement project or some other reason.
Regardless, you should identify all the reasons behind your desire to refinance because it does mean a new loan.
2. Review your credit, DTI, and income. Before you go to the bank, you should acquire your credit reports from the three bureaus along with your credit score.
You need to know whether they contain any errors that could affect your ability to qualify. You should also know what all is on there, so you know what the bank is going to see.
Your debt-to-income ratio, or DTI, is important as well because it tells a prospective lender how much debt you can afford. You might have a mortgage now, but chances are your financial situation has changed.
If your DTI is too high, the bank may decide you're too much of a risk now.
If you've changed jobs or been promoted, your income has changed as well.
In short, your finances probably aren't what they were when you got your first mortgage, so be sure of what the picture is now before you fill out your application. Your DTI should be no more than 45 percent of your monthly income.
3. Find out how much equity you have in your home. Your equity is the amount of value in your house that doesn't serve as collateral for your loan.
To put it in simpler terms, if you bought a house for $120,000 and put 20 percent down, your original mortgage was $96,000, giving you $24,000 worth, or 24 percent equity in your home.
However, since you've been making payments, perhaps you only owe $70,000 now. If your home's value increased to $150,000 as your mortgage decreased to $70,000, you now have $80,000 worth, or 55 percent equity in your home.
The more equity you have, the more you can borrow without having insurance tacked onto your payment. You're also more likely to qualify for a good interest rate. As such, knowing your equity is essential.
4. Compare lenders rates and fees. Not all lenders are equal. Some will give you better rates and fees than others. Do some shopping and find out what various lenders in your area are offering.
Doing your homework can save you a lot of time and money.
5. Get a loan estimate. As you did when you got your first mortgage, you need to get a loan estimate. It will tell you a lot about how different lenders work, along with whether you should bring cash to closing or if your lender will roll those costs into your total loan.
You'll also further refine your search for a good lender. This dovetails with item four on our list. With the internet, you can fill out loan applications and get multiple estimates quickly.
6. Prepare your documents and application. You'll have to apply for a loan to get an estimate, so here's what you'll need to go with it:
- Tax returns and W2s
- Pay stubs
- Details on assets and investments outside of retirement accounts
- Information on retirement accounts and other bank accounts, including savings
- A government-issued ID
Lenders use these things to verify your income and your assets. This is in addition to the hard credit check they'll perform to see whether you're a good risk.
Remember, a lot can change between the time you get your first mortgage and the time you refinance, so lenders treat it for what it is: A new home loan application.
7. Close on the Loan. This is the last thing you'll do like it was when you closed on your first mortgage. You'll have to go through all the loan documents and sign them in many places.
Someone will be there to help you understand what you're reading and signing, and they will witness your signatures.
You might go to an office to close, or the loan officer might come to your house. For refinancing, it's often more convenient and less costly for your lender if they come to your house for closing.
The only difference is that, once you've closed, you only have loan documents to put away and a feeling of success that you've achieved whatever you set out to do when you decided to refinance.
When you refinance, keep in mind that you're taking out a completely new mortgage. It will come with terms that are more favorable to your situation than your current loan, but you're getting an all-new loan with brand-new pros and cons.
It's not hard to refinance if you know what you're doing. The biggest thing is how you organize your refinance before you close. Follow these steps, and then barring complications with qualifying, you should have no problems.
Mortgage Refinance FAQ's
We know that refinancing is a complicated subject, so we're answering some of the most commonly asked questions about it.
Mortgage refinancing involves applying for a brand new mortgage with new terms that pay off the one you have now, thus eliminating the old terms.
The new loan will likely have benefits the old one didn't, including a lower interest rate or no mortgage insurance. It might have a fixed interest rate while your old one had an adjustable rate, or it might have many other differences.
That depends on your situation and why you want to refinance. When you take out a new 30-year mortgage, you push your payoff date back by years, and you end up paying more in interest over the combined lives of both mortgages.
However, many people who refinance don't care about how long they'll owe money to the bank or how much interest they'll ultimately pay. They're taking the opportunity to lower their monthly expenses or tap into their equity.
Make a list of pros and cons relevant to your situation to decide whether or not to take out a new 30-year home loan.
Both involve getting a new loan, but a cash-out refinance involves borrowing more than necessary to pay off your current mortgage. How much extra you can borrow depends on the equity you have in your house.
When you do a cash-out refinance, you get cash back at closing. People often use the extra cash for major projects like home renovation.
You get many benefits from refinancing your mortgage. Some of the most common include:
- Lower interest rates
- Lower monthly payments
- Shorter payoff term
- Cashing in on some of your equity
Like anything having to do with debt and housing, refinancing isn't without its risks.
Some of the risks of refinancing are:
- Closing costs may not get rolled into the loan
- If closing costs are rolled into the loan, they increase your loan amount
- You might not recoup those costs with savings on your payments
- You might get less back if you sell too soon