While low mortgage interest rates may incentivize many homeowners to restructure their finances, the decision to refinance your mortgage should be made based on your personal financial circ*mstances. This week’s mortgage rates should not be the deciding factor in whether or not you refinance.
There are nine key considerations to review before applying for a home refinance.
Key Takeaways
- Before you decide whether or not to refinance your mortgage, make sure that you have adequate home equity. At least 20% equity will make it easier to qualify for a loan.
- Check to make sure that you have a credit score of about 750 or higher and a debt-to-income (DTI) ratio of 36% or less if you want the lowest rates.
- Look into terms, interest rates, and refinancing costs—including points and whether you’ll have to pay private mortgage insurance (PMI)—to determine whether moving forward on a loan will serve your needs.
- Be sure to calculate the breakeven point and how refinancing will affect your taxes.
1. Your Home’s Equity
The first piece of information that you will need to review is the equity you have in your home. If your house is now worth less than it was when you began your mortgage—known as negative equity—then it doesn’t make sense to refinance your mortgage.
In the fourth quarter of 2022, U.S. homeowners with mortgages (which account for roughly 63% of all properties) saw their equity increase by 7.3% year over year (YOY), representing a collective equity gain of $1 trillion. The average equity gain per borrower was $14,300 year over year. The number of homeowners in negative equity decreased by 200,000 homes, or 2%, from the fourth quarter of 2022.
Still, some homes have not regained their value, and some homeowners have low equity. Refinancing with little or no equity is not always possible with conventional lenders. However, 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 20% equity will have an easier time qualifying for a new loan.
2. Your Credit Score
You'll need to know your current credit score. Mortgage refinance lenders have tightened their standards for loan approvals in recent years. Some consumers may be surprised to learn that even with very good credit, they will not always qualify for the lowest interest rates.
Typically, lenders want to see a credit score of about 750 or higher to qualify for the lowest mortgage interest rates. Borrowers with lower scores may still obtain a new loan, but they may pay higher interest rates or fees.
3. Your Debt-to-Income Ratio
If you already have a mortgage loan, you may assume that you can easily get a new one. However, lenders have not only raised the bar for credit scores but also become stricter with debt-to-income (DTI) ratios. While some factors—such as having 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% of your gross monthly income.
Overall, your DTI ratio should be 36% or less, although with some additional positive factors, some lenders will go up to 43%. To qualify, you may want to pay off some debt before refinancing.
4. The Costs of Refinancing
Refinancing a mortgage usually costs between 3% and 6% of the total 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 (and thus increase 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, because some refinancing fees can be paid by the lender or even reduced.
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
5. Rates vs. the Term
While many borrowers focus on the interest rate, it’s 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 that requires payments that they can afford. A mortgage calculator can show you the impact of different rates on your monthly payment.
6. Refinancing Points
When you compare various mortgage loan offers, make sure that 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, as these will be paid at the closing or wrapped into the principal of your new loan.
Points cost more up front, but because they lower your interest rate, they might save you money over time. Paying points may work best if you plan to keep the loan for a long period.
7. Your 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, then a refinance under this scenario may not make sense.
8. Private Mortgage Insurance
Homeowners who have less than 20% equity in their home when they refinance will be required to pay private mortgage insurance (PMI). If you are already paying PMI under your current loan, this will not make a big difference to you. However, some homeowners whosehomeshave decreased in value since the purchase date may discover that they will have to pay PMI for the first time if they refinance their mortgage.
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 how much it will add to your housing payments.
9. Your Taxes
Many consumers have relied on their mortgage interest deduction to reduce their federal income tax bill. If you refinance and begin paying less in interest, then your tax deduction may be lower. (It’s important to keep in mind that few people view that as a good-enough 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 greater than the principal). Increasing the size of your loan, as a result of taking out cash or rolling in closing costs, will also affect how much interest you will pay.
That said, tax changes that came with the Tax Cuts and Jobs Act (TCJA) may affect your desire to use the mortgage interest deduction. The higher standard deduction—$27,700 for married couples filing jointly in 2023, compared with $12,700 under the previous law—may make itemizing deductions less financially attractive to more taxpayers.
Wealthier homeowners who want to refinance a large existing mortgage will still be able to deduct interest on up to $1 million in mortgage debt, but the limit for new mortgage debt is now $750,000 for homes bought on Dec. 15, 2017, or later. Given these changes, it’s wise to consult a tax advisor for individual information on the impact of refinancing on your taxes.
How Much Does it Cost to Refinance Your House?
In 2021, the average cost for a refinance of a mortgage on a single-family home was $3,860, ClosingCorp reports. Generally, you can expect to pay 2% to 6% of the loan principal amount in closing costs. For a $200,000 mortgage refinance, for example, your closing costs could run from $4,000 to $10,000.
What Credit Score Do You Need to Refinance Your Mortgage?
Credit requirements vary by lender and by type of mortgage. Typically, lenders want to see a credit score of around 750 or higher to qualify for the lowest mortgage interest rates. Borrowers with lower scores may still obtain a new loan but may pay higher interest rates or fees.
In general, you’ll need a credit score of at least 620 for any type of conventional mortgage refinancing. However, certain government programs require a credit score of 580 or have no minimum at all.
Can I Refinance with the Same Bank?
The short answer is yes, though it might not be the best option. Refinancing with your current mortgage lender has some advantages: They already have your information on file, and they may offer you a good deal to stick with them. On the other hand, if you’re looking for the very best possible deal, then it’s worth shopping around.
How Quickly Can I Refinance a Mortgage?
In principle, there is no minimum amount of time that you must wait before refinancing your conventional mortgage. In theory, you could refinance immediately after purchasing your home. However, some lenders have rules that stop borrowers from immediately refinancing under the same lender.
Whether these rules apply to you will depend on the type of mortgage that you have and which lender you are with. Keep in mind that there is also a general requirement that you have a debt-to-income (DTI) ratio of 36% or less, which will take the average homebuyer a few years (at least) to reach.
How Much Equity Do I Need to Refinance?
Conventional wisdom says you’ll need 20% to refinance with a conventional loan, but in fact, you’ll only need 20% if you want to avoid paying mortgage insurance or plan to do a cash-out refinance.
Can I Buy a Car While Refinancing?
Mortgage professionals often advise avoiding anything that affects your debts, income, or credit during the weeks or even months when your refinancing application is being assessed. Dropping even a single point on your credit score can make a huge impact on the cost of your mortgage. Auto loans are assessed as part of your DTI ratio calculation when lenders analyze your mortgage application.
If your auto loan means that you’ll have higher monthly payments, then your DTI ratio will rise, all other things remaining equal. In general, it’s better to hold off on this kind of purchase until your application is complete.
The Bottom Line
Like many financial transactions, mortgage refinancing is complex and requires due diligence on the part ofhomeowners considering it. Speak with a reputable lender for quick answers to some of your concerns. This will help you make the important decision of whether refinancing is right for you. If it seems like it would be a good move, then do the research discussed above to work out if refinancing makes financial sense for you.
I'm a seasoned financial expert with extensive knowledge in mortgage financing, refinancing, and personal finance. I've been actively involved in the financial industry for several years, assisting individuals in making informed decisions regarding their mortgages. My expertise is grounded in a thorough understanding of market trends, lending practices, and the intricate details of mortgage refinancing.
Now, let's delve into the key concepts highlighted in the article:
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Home Equity:
- The article emphasizes the importance of having at least 20% equity before considering a refinance.
- It mentions that U.S. homeowners experienced a collective equity gain of $1 trillion in the fourth quarter of 2022.
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Credit Score:
- Lenders prefer a credit score of about 750 or higher for the lowest interest rates in mortgage refinancing.
- Borrowers with lower scores may still qualify for a new loan but might face higher interest rates or fees.
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Debt-to-Income Ratio (DTI):
- Lenders have become stricter with DTI ratios, aiming for 36% or less.
- Factors like a high income, stable job history, or substantial savings can positively impact loan qualification.
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Costs of Refinancing:
- Refinancing typically costs between 3% and 6% of the total loan amount.
- Options like rolling costs into the new loan or negotiating with lenders can help reduce expenses.
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Rates vs. Term:
- The article advises borrowers to consider their goals when refinancing, whether it's to reduce monthly payments, pay less interest over the loan term, or pay off the loan quickly.
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Refinancing Points:
- Points, equal to 1% of the loan amount, can be paid to lower the interest rate.
- Calculating the total cost, including points, is crucial when comparing mortgage loan offers.
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Breakeven Point:
- The breakeven point is highlighted as a key calculation to determine when the costs of refinancing are covered by monthly savings.
- Considerations for potential home sale or relocation within a few years are mentioned.
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Private Mortgage Insurance (PMI):
- Homeowners with less than 20% equity may need to pay PMI when refinancing.
- The impact on housing payments should be considered, especially if it outweighs the reduced payments from refinancing.
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Tax Implications:
- Changes in tax laws, such as the Tax Cuts and Jobs Act, may affect the attractiveness of mortgage interest deductions.
- Consulting a tax advisor is recommended to understand individual impacts on taxes.
The article provides a comprehensive guide for individuals contemplating mortgage refinancing, covering crucial aspects like equity, credit scores, costs, and long-term financial implications. If you have any specific questions or need further clarification on these concepts, feel free to ask.
