How Do You Refinance a House?
You may have questions about refinancing your house. The good news for anyone who has already been through the mortgage process to purchase the house they want to refinance is that the two processes are very similar. However, that doesn't necessarily mean that anyone who owns a home is automatically prepared to refinance. This article covers the basics steps of the refinancing process.
What Does It Mean to Refinance a House?
When you refinance, you're essentially trading in your current mortgage for a new one on the same home. Most mortgage refinances leave the borrower with a new principal and interest rate. People refinance their homes for a variety of different reasons. In many cases, the goal is to lower monthly mortgage costs by switching to a lower interest rate. This is especially common among people who have seen rates drop since purchasing their homes. Other people refinance in order to do a cash-out refinance that allows them to fund home renovations or other expenses.
Benefits of refinancing
The most obvious benefit of refinancing a home is reducing monthly payments using a lower interest rate. This perk can also help to reduce the overall lifetime cost of a mortgage. Some people also use refinancing to adjust their principal in order to eliminate the monthly private mortgage insurance (PMI) they've been paying on a loan. If a homeowner is concerned about an adjustable-rate mortgage (ARM) that is about to reset to a higher rate, they can use a refinance to switch to a fixed-rate mortgage to enjoy more predictability in their monthly payments.
Another benefit of refinancing a home is that you can change the term of a mortgage. For example, someone who would like to pay off a 30-year mortgage faster can switch to a 15-year mortgage. It's also possible to go from a 15-year mortgage to a 30-year mortgage in order to reduce monthly payments if your financial goals change.
Finally, people who opt for a cash-out refinance or home equity line of credit (HELOC) when refinancing get the benefit of tapping into a home's equity without selling it. Home equity is the difference between a home's worth and the amount owed on the mortgage. By using home equity to obtain cash, some homeowners find that they are able to fund projects or pay off debt using terms that are more favorable than what's offered through a conventional personal loan or home-improvement loan.
Factors to consider before refinancing
For the average person looking to refinance a home, the biggest factor is the current interest rate versus the rate they locked in when they bought their home. If rates are lower today than they were on closing day, it's possible to save money by refinancing. However, some people who are refinancing in order to get rid of PMI could come out on top even if rates are either stagnant or slightly higher compared to when they purchased their homes. This is where sitting down with a lender to crunch the numbers becomes important.
Credit score is another major factor in the decision to refinance a home. As most people know, interest rates fluctuate based on a mix of market forces and decisions from the Federal Reserve. However, a person's credit score can determine whether they get offered rates on the higher or lower side of the current market average. Has your credit score improved significantly since you closed on your current mortgage? It might be worth seeing if you can be approved for a lower rate.
For borrowers who are interested in a cash-out refinance, knowing how much equity is in your home is important. Generally, 20% equity is required to be approved for a home refinancing. It's also important to know the fine print of your mortgage. In mortgages with prepayment penalties, fees may kick in for homeowners who refinance within three years of closing.
When to Refinance a Mortgage?
The simple answer is that the right time to refinance your mortgage is when it makes financial sense. While there's no requirement that a person needs to refinance at a specific stage, many people consider refinancing to be a smart strategy for letting their home's value and strong credit score help them to reach their financial goal faster. How long before you can refinance a house? Most lenders require you to wait six months after purchase. However, there are no restrictions on cash-out refinancing if you own a home without a mortgage.
Evaluating Your Home Equity
Home equity is the difference between what a home is worth (fair market value) and the outstanding balance on a mortgage. It essentially refers to the portion of the home that the homeowner already owns. While home equity takes the spotlight during a cash-out refinance, it is still important during a traditional refinance because a lender can't give you a new loan for more than what your home is currently worth.
Calculating home equity
The first step to calculating equity is getting an idea of your home's current value. This won't necessarily be the amount that you paid for the home. Next, subtract any outstanding balances on the property. For a home valued at $500,000 that has a mortgage balance of $250,000, the owner would have $250,000 in equity.
Using home equity to refinance
Refinancing is a vehicle that lets you access the equity that is sitting in your home. Many people prefer this option when they need financing for major home renovations. However, cash-out refinancing agreements generally allow homeowners to use the equity they pull out for any reason. That includes paying off debt. When using cash-out or HELOC options, borrowers work out repayment periods with their lenders.
Assessing Your DTI Ratio
Home equity isn't the only major figure that's looked at during refinancing. Lenders also look heavily at something called the debt-to-income ratio (DTI). In simple terms, DTI refers to a comparison of a person’s income to what they spend each month.
A person's DTI is determined by dividing all monthly debts and expenses by gross monthly income. It's one of the best tools lenders have for ensuring that a borrower can manage their new monthly payments.
To calculate DTI, add up all of your monthly debt payments. Next, divide that figure by your monthly gross income before taxes and other deductions are removed. Let's say a person with gross monthly income of $5,000 pays $1,300 for a mortgage, $200 in auto loans, and $300 for the rest of their debts. This would add up to $1,300 + $200 + $300 = $1,800 per month in expenses. With $1,800 being 36% of $5,000, this places the borrower's DTI right at 36%.
Impact of DTI ratio on refinancing eligibility
Most lenders like to see a DTI below 36%. However, lenders may go as high as 45%. With DTI being just one of many factors, it's important to speak with a lender about the "whole picture" when considering a home refinance.
Exploring Different Mortgage Refinancing Options
There are many different refinancing options for many different types of borrowers. Each option comes with its own requirements and fees. Which one might be right for you? Here's a glance at ways to refinance a home:
- FHA Streamline Refinancing: The Streamline Refinancing program allows borrowers with FHA-insured loans to refinance to a lower interest or switch to a different type of mortgage using a qualified lender. While this isn't a fee-free refinancing option, it does require limited underwriting and documentation compared to other refinancing channels. New appraisals aren't required.
- Conventional Loan Refinancing: Conventional refinancing allows borrowers to update Conventional, FHA, or VA loans into new Conventional loans. Requiring more documentation and a higher credit score than FHA refinancing, conventional refinancing gives borrowers robust options for rate-based, term-based, or cash-out refinances.
- Cash-out Refinancing: For borrowers with enough home equity, cash-out refinancing makes it possible to refinance a loan to access what they own in their homes today.
- VA Refinancing: For qualifying borrowers, the VA Streamline/Interest Rate Reduction Refinance (IRRRL) or VA cash-out refinance can make lowering interest rates or monthly payments possible.
Mortgage Refinancing Costs
How much is it to refinance a house?
Refinancing options come with upfront costs that mirror the closing costs paid when buying a home. For most borrowers who refinance, costs total anywhere from 2% to 5% of the loan.
How will refinancing impact monthly payments?
In most cases, monthly mortgage payments will dip after refinancing to a lower rate. However, borrowers who choose to jump from a 30-year loan to a 15-year loan in order to pay off a home sooner will see an increase.
Calculating closing costs
Lenders are required to provide a five-page document called a Closing Disclosure that outlines all of the closing fees for mortgages and refinances. To estimate closing costs, you'll need to look at your loan amount, desired term, anticipated interest rates, and any closing fees tied to origination, titles, insurance, underwriting, and appraisals. These fees can vary based on lender and location.
Assessing the overall cost of refinancing
To see if refinancing saves you money, compare current monthly loan payments to the anticipated payments of the new loan. Next, look at an amortization schedule to compare the balances on both loans using the same number of payments to calculate your savings.
Considering the impact on credit score
Refinancing can temporarily harm your credit score based on the hard inquiries that are made during the application process. Most borrowers are happy to take the "ding" because a score will typically bounce back within a few months as long as no other major changes are made. Ultimately, most people find that refinancing actually helps their credit in the long term by lowering their monthly debts.
Downsides of Refinancing a Mortgage
While many people find that refinancing aligns with their financial goals, the choice comes with its unique set of pros and cons. Here are the potential downsides to know about:
- More Interest: If you're applying for a cash-out refinance when rates are higher than your original rate, you may end up with a higher interest rate in order to access your home equity.
- Potential for Higher Payment: Some situations where a borrower might end up with a higher monthly payment include switching to a different loan term, folding closing costs into a loan balance, or pulling equity out of a home.
- Closing Costs Can Be Expensive: With closing costs totaling 2% to 5% of a loan for most refinances, borrowers generally need to be prepared to come up with cash to close.
- Market Conditions Can Affect Your Options: While credit scores can impact the interest rates lenders will offer, the market ultimately determines rates.
- Hard Inquiries Can Impact Credit: Most people who refinance see their credit scores temporarily dip for several months following closing. This could harm your ability to obtain financing.
- Missing a Payment Could Hurt Your Credit: Not keeping up with new loan terms following a refinance can harm your credit score. That could make it more difficult to qualify for a future mortgage or personal loan.
- Loan Starts Over: Refinancing means starting over with a brand new loan. For borrowers who don't switch to a shorter loan term, that means that closing day is the first day of a 30-year mortgage.
FAQ
What are the disadvantages of refinancing your mortgage?
While refinancing can lower monthly payments or shorten the life of a loan for many borrowers, the downsides include paying closing costs, taking a temporary hit to your credit score, and starting your loan over from scratch.
How long does it take to refinance a house?
Most people are able to complete the refinance process in 30 to 40 days. However, individual circumstances will vary.
How often can you refinance your house?
There is no limit to how many times a home can be refinanced. However, some lenders do have waiting periods.