How Does Mortgage Refinancing Work?
Point of Interest
If you are considering applying for a mortgage refinance, you first need to know the answers to the following questions: how does refinancing work, is it worth it and how do you do it? Once you have that information, you can make an educated decision on whether or not to refinance your home loan.
What is refinancing a home? Refinancing a home is essentially swapping out the loan on your home for a new one with new terms and rates. When you first applied for a loan, you may have taken out a 30-year mortgage loan. However, you don’t need to stay with that same agreement for 30 years. You can refinance your home to a different term length or rate, which can offer several benefits.
Refinancing a home can help you save money, build equity faster or eliminate mortgage insurance. But how does refinancing work and how do you qualify for refinancing?
How does mortgage refinancing work?
Refinancing a mortgage follows a similar process to getting a new mortgage. The process involves a lot of research and you will want to shop around for the best refinance interest rates and loan terms that different lenders have to offer. The main difference is that all of the rates and terms you look at will be compared to your current loan to decide if you can get a better deal.
If your financial or credit circumstances have changed for the better since you first took out your loan, you may be able to get a more favorable deal this time around. For example, you may have a better credit score to unlock better interest rates, which will lower your monthly payment and the amount you pay on your loan over the long run.
However, while you can benefit from lower rates or new terms with a refinance, you also need to keep an eye on closing costs. A refinance is essentially a brand new loan, so you will likely pay similar closing costs as when you first took out your loan. In some cases, you may be able to add these costs to the loan amount, but some lenders will require an upfront payment instead.
Any savings you think you will get from refinancing should have the closing costs factored in as well to see what your real saving will be. It could take you a while to break even on the cost of refinancing your mortgage when you factor in the closing costs, but it could still be worth it.
Do I qualify for mortgage refinancing?
As part of your research, you should also look at whether you qualify for refinancing. Qualifying for refinancing will depend on your credit, income and the equity you have in your home. All of these factors can make or break an approval with a lender.
In general, you can qualify for refinancing with average or better credit scores and other acceptable financial factors, like a low debt-to-income ratio and enough equity paid into it. The parameters for approval will vary by lender, though.
If your mortgage is in forbearance due to COVID-19, you may be wondering whether you qualify at all. The government is allowing refinancing on mortgages in forbearance, so you may also have a chance in this case as well. You must continue to make upcoming payments after forbearance and meet other requirements to qualify for this.
Spend some time looking at credit requirements for various lenders and also get a copy of your current credit scores and reports. Looking at your full credit report allows you to identify any errors and also highlights whether you need to work improving your financial track record so that your application stands a better chance.
Naturally, lenders need to know that you will be able to repay your mortgage. This is especially important if you are refinancing to a shorter loan term, as monthly repayments are likely to increase with a shorter loan. Lenders need to see proof that you can handle those payments before extending a loan.
Lenders will use your loan-to-value ratio (LTV), which is the amount you owe on your mortgage compared to the market value of your home, to assess your risk. The higher this ratio, the riskier your application will appear.
The step-by-step process of refinancing
Step 1: Decide why you want to refinance.
Having a clear financial goal in mind is the first step. Are you looking to reduce your monthly payments, build equity faster, take cash out of your equity or shorten your loan term? If you are looking to reduce your interest rate but want to take out another 30-year mortgage, you could end up paying back more interest overall since your loan term starts over with the new loan.
Step 2: Check your credit score.
Once you are happy with your reasons for going ahead with a refinance, your next step is to look at your credit score. Your credit score will determine whether a lender approves you for a new loan and what refinance rates you’re offered. The better your credit score, the more favorable terms you will be offered.
Step 3: Check your home equity.
Your home equity will also be a factor in a lender’s decision to approve you, especially if you are taking out a cash-out refinance. Ideally, you will have at least 20% equity in your home for better refinance rates and cash-out refinancing terms.
Step 4: Shop around for the best rates.
It’s time to do your research and start shopping around. Make sure you get quotes from multiple lenders before agreeing to one. This can save you thousands on your loan refinancing costs and interest rate. Once you are happy with a rate, make sure you lock in your rate so it doesn’t fluctuate.
Step 5: Submit all your details.
Make sure you are transparent about your financial situation and promptly hand over all the documents and evidence that the lender requires. Having all of this ready before you start can help speed the process up.
Step 6: Prepare your closing costs.
If you are required to hand over upfront closing costs, you’ll do it at your loan closing. In many cases, these costs can be added to the loan, but you will likely pay more overall if that’s the route you take.
Should I refinance now?
Deciding on whether this is the best time to refinance will depend on your current circumstances. It’s also important to weigh up the benefits and downsides of refinancing before you make a firm decision.
The benefits of refinancing your mortgage include:
- Taking advantage of lower interest rates
- Switching to a shorter term can save you money on interest rates
- A shorter loan can help you build up equity faster
- You can take cash out if you have enough equity
While interest rates may be fairly low right now, that doesn’t mean it’s time to refinance your mortgage. There are some downsides to refinancing, including:
- Additional closing costs, which take a while to break even on
- A new term may increase the amount you pay overall, even if it reduces your monthly payment
- A cash-out refinance will result in a higher loan amount overall
Before you decide to refinance, determine what your goal for refinancing is and whether it can help you save money both in the short and long-term.
Another thing to keep in mind is that we are heading into a recession due to the pandemic, which could make refinancing a bit riskier. You may need to look into the COVID-19 impact on refinancing and assess the risk of taking out a new loan.
The final word
Mortgage refinancing can be just as complicated as taking out a mortgage the first time. It’s important to have a solid plan of action and goal for your refinance if you want to make sure it’s worth your time and effort. With a firm plan and an idea of what you want to achieve, you stand a better chance of getting a good deal and saving money on your mortgage.