Refinancing applications represented approximately 80% of all mortgage loan applications in September 2010, according to the Mortgage Bankers Association (MBA), in part because extremely low mortgage interest rates encourage homeowners to restructure their finances. But whether or not a mortgage refinance is right for you depends more on individual circumstances than this week's mortgage interest rates. Here are a few considerations to think about before applying for a home refinance:
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- Home Equity
The first qualification you will need in order to refinance is equity in your home. Dropping home values across the country have left many Americans "underwater", owing more to their mortgage lender than their home's current market value. Other homeowners have low equity. Refinancing with little or no equity is not always possible with conventional lenders, but some government programs are available. The best way to find out if you qualify for a particular program is to visit a lender and discuss your individual needs. Homeowners with at least 10-15% equity will have an easier time qualifying for a new loan.
- Credit Score
Lenders have tightened their standards for loan approvals in recent years, so some consumers may be surprised that even with good credit they will not always qualify for the lowest interest rates. Typically, lenders want to see a credit score of at least 720 or higher in order to qualify for the lowest mortgage interest rates. Borrowers with lower scores may still obtain a new loan, but the interest rates or fees they pay may be higher.
- Debt-to-Income Ratio
If you already have a mortgage loan, you may assume that you can easily get a new one. But lenders have not only raised the bar for credit scores, they have also become stricter with debt-to-income ratios. While some factors such as a high income, a long and stable job history or substantial savings may help you qualify for a loan, lenders usually want to keep the monthly housing payments under a maximum of 28% to 31% of your gross monthly income. Overall debt-to-income should be 36% or less, although with some additional positive factors some lenders will go above 40%. You may want to pay off some debt before refinancing in order to qualify.
- Refinancing Costs
A home refinance usually costs between 3% and 5% of the loan amount, but borrowers can find several ways to reduce the costs or wrap them into the loan. If you have enough equity, you can roll the costs into your new loan, increasing the principal. Some lenders offer a "no-cost" refinance, which usually means that you will pay a slightly higher interest rate to cover the closing costs. Don't forget to negotiate and shop around, since some refinancing fees can be paid by the lender or reduced.
- Rates vs. Term
While many borrowers focus on the interest rate, it is important to establish your goals when refinancing to determine which mortgage product meets your needs. If your goal is to reduce your monthly payments as much as possible, you will want a loan with the lowest interest rate for the longest term. If you want to pay less interest over the length of the loan, look for the lowest interest rate at the shortest term. Borrowers who want to pay off their loan as fast as possible should look for a mortgage with the shortest term at payments they can afford.
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When you compare various mortgage loan offers, make sure you look at both the interest rates and the points. Points, equal to 1% of the loan amount, are often paid to bring down the interest rate. Be sure to calculate how much you will pay in points with each loan, since these will be paid at the closing or wrapped into the principal of your new loan.
- Breakeven Point
An important calculation in the decision to refinance is the breakeven point, the point at which the costs of refinancing have been covered by your monthly savings. After that point, your monthly savings are completely yours. For example, if your refinance costs you $2,000 and you are saving $100 per month over your previous loan, it will take 20 months to recoup your costs. If you intend to move or sell your home within two years, a refinance under this scenario may not make sense.
- Private Mortgage Insurance (PMI)
Homeowners who have less than 20% equity in their home when they refinance will be required to pay PMI. If you are already paying PMI under your current loan, this will not make a big difference to you. But some homeowners who own homes that have decreased in value since the purchase date may discover that when they refinance they will need to start paying PMI for the first time. The reduced payments due to a refinance may not be low enough to offset the additional cost of PMI. A lender can quickly calculate whether you will need to pay PMI and the impact on your housing payments.
Many consumers rely on their mortgage interest deduction to reduce their federal income tax bill. If you refinance and begin paying less in interest, your tax deduction may be lower, although few people view that as a reason to avoid refinancing. However, it is also possible that the interest deduction will be higher for the first few years of the loan when the interest portion of the monthly payment is higher than the principle. Increasing the size of your loan due to taking cash out or rolling in closing costs will also impact the amount of interest you will pay. Points paid during a refinance can be deducted over the life of the new mortgage loan. Consult a tax advisor for individual information on the impact of refinancing on your taxes.
The Bottom Line
Like many financial transactions, mortgage refinancing is complex and requires due diligence on the part of the homeowners. However, a reputable lender can provide quick answers to some of your concerns and help you make the important decision as to whether refinancing is right for you. (For related reading, take a look at How Refinancing Affects Your Net Worth.)
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