Deciding to refinance your home

When interest rates are low, you may hear your friends and family members talking about refinancing. While refinancing your mortgage can help you save money in some cases, every situation is different. Understand the basics of refinancing to determine if refinancing can help you take control of your housing costs.

The basics of refinancing

Refinancing allows you to change the terms of your mortgage, which is the loan you’ve secured to purchase your home. When you refinance, you essentially pay off your original mortgage and replace it with a new one, with different terms and interest rates. This means you may be able to decrease the cost of your mortgage by taking advantage of lower interest rates (meaning lower monthly payments), adjusting the length of your loan, or switching from one type of mortgage to another.

Because you’re securing a new mortgage, you’ll be responsible for many of the same costs that came with your original mortgage—closing costs, attorney’s fees, insurance, an appraisal, taxes, etc. So, if you’re thinking about refinancing, you need to determine whether the savings you’ll get from a lower interest rate or other changes in the terms of your loan will make up for the costs you’ll incur.

So how does refinancing help?

Despite the costs that come with it, refinancing can help you come out ahead financially. By locking in a lower interest rate, you can reduce your monthly loan payment. You can use your monthly payment savings—the difference between what you pay before and after refinancing—to reduce debt or work toward another long-term savings goal.

Or, you can also use refinancing as a way to pay off your mortgage more quickly. Generally, during the early years of a mortgage, interest takes up a large portion of the monthly payment. If you refinance and lock in a lower interest rate, your monthly payment should go down. However, if you can afford to continue paying the same amount you were paying before, you’ll pay less in interest and more toward the principal (the amount you borrowed)—and be able to pay off your home more quickly.

How do I know if refinancing is right for me?

There are several factors to consider when deciding if refinancing may be right for you:

• How long you plan to stay in your current home. If you think you will move in the next few years, it may not make sense to refinance.
• Your financial situation. Although it’s generally easier to refinance than to secure an original mortgage, your mortgage lender will still evaluate your financial situation and ability to repay your new mortgage. If you don’t already know your credit score, request a credit report. Your score will play a large part in whether you qualify for refinancing. Plus, you’ll need to have a certain amount of equity in your current home to qualify, which is essentially the difference between the value of your property and the amount you owe on your mortgage. Talk to a few potential lenders about their requirements.
• Your current mortgage terms. Before you go through the effort to refinance, check the fine print of your current mortgage. Since mortgage lenders make their money on the interest payments you make, some mortgages come with pre-payment penalties in case you pay off your loan early. If your mortgage has a pre-payment penalty, ask your lender if the penalty can be waived. If not, make sure you carefully compare the cost of the pre-payment penalty with the savings you expect to gain through refinancing. Or, if you have an adjustable rate mortgage (ARM), you may miss out on potential savings if you refinance to another type of mortgage before the ARM’s initial low rate expires.

What steps will I need to take to apply to refinance?

Just like with your original mortgage, you’ll need to submit a formal mortgage application in order to refinance. Before you do that, follow the steps below to save time:

• Organize your paperwork. Refinancing requires a lot of paperwork, including pay stubs, bank and financial statements, and W-2s. Gathering these documents up front will make the application process easier.
• Determine if you qualify. As mentioned, your current financial situation will determine your ability to refinance. In addition to your credit score, lenders will evaluate your ability to pay your mortgage by looking at both your monthly income and your monthly debt through what’s called a debt-to-income ratio (DTI). As you research lenders, ask what their requirements are—it will save you time if you learn early on that you won’t qualify.
• Research lenders. Start with your current lender and research others, including mortgage brokers, credit unions, and local banks, to find the best rate. Gather information about closing costs as well as term and interest rate options. Ask for loan information in writing before you pay a nonrefundable application fee.
• Compare apples to apples. Closing costs, third party fees, and the cost of originating a loan can add up quickly. When comparing lenders, you’ll want to look at the total cost of the refinance. Ask for an estimated annual percentage rate (APR) so that you can make your loan decisions based on true cost. Plus, confirm that each quote you receive is for the same type of loan—you don’t want to be swayed by an “amazing deal” that could be slightly different on paper than what you requested.

The bottom line

Refinancing may be a great way for you to reduce your monthly housing costs, or pay off your home more quickly. That said, it’s not right—or available—for everyone. If refinancing doesn’t make sense for you now, that doesn’t mean it won’t be an option in the future.

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