6 Steps to Check Before Refinancing Your Mortgage

By Selena Maranjian Markets Fool.com

A recent study has estimatedthat $5.4 billion was left on the table by homeowners who didn't refinance their mortgages when they could have. The researchers found that, while most folks who could benefit did indeed refinance, about 20% did not. If you're carrying a mortgage, it's worth finding out whether you can save by refinancing.

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Refinancing is when you essentially trade in your current mortgage for a newer one -- ideally one with more attractive terms. The first loan gets paid off by the new one. Here are some steps you need to check before refinancing. They can help you think through and decide whether refinancing makes sense for you.

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Step 1: How much lower is the interest rate you can get?

First off, there's a rule of thumb that says, if current interest rates are at least about a percentage point higher than your current loan's rate, refinancing is likely to be worthwhile. Don't be rigid with the rule, but if the difference in rates is close to a whole percentage point, it's worth taking a closer look at refinancing.

As an example, the national average interest rate for a 30-year fixed-rate mortgage wasrecently 4.32% -- up from 3.77% a year earlier. If your 30-year loan is carrying a rate of about 5.3% or more, refinancing is likely to make sense.

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A Bankrate.com mortgage calculatorreveals that a standard $200,000 loan will sport monthly payments of $1,111 at an interest rate of 5.3%, but just $990 at 4.3%. That's a meaningful difference of $121 per month, or $1,452 per year.

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Step 2: Do you have 20% equity in your home?

Another question to ask yourself is, how much equity do you have in your home? Lenders will generally require that you buy private mortgage insurance (PMI) if you don't have 20% equity. It's the same when you get an initial mortgage: If you pay less than 20% down, PMI is likely in the cards, adding to the expense of paying for your home.

Even if you paid 20% down, though, if your home's value has fallen, your equity in it may no longer be 20%. (Indeed, some people are "underwater" on their loans -- meaning that they currently owe more than their homes are worth. That can make it hard to sell the home, and hard to refinance, too.)

Step 3: How much debt are you carrying?

Next, consider how much overall debt you're carrying, from all sources -- such as your home loan, car loans, credit card debt, and so on. (Student loans can count, too, if they're not currently deferred.) Lenders don't want you to owe too much relative to your earnings, as that could make you a shakier borrower, so they pay close attention to your debt-to-income ratio.

To calculate your debt-to-income ratio, divide the total of all your monthly debt payments by your gross monthly income. To qualify for most mortgages, you'll want your debt-to-income ratio to be no more than 43% --and ideally, lower.

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Your debt-to-income ratio may have been fine when you originally bought your house, but if you have since taken on more debt, you may be a less promising borrower today. If so, it could be worth spending a little time paying down your debt before refinancing.

Step 4: How's your credit score?

Meanwhile, give your credit score a close look, too. In order to offer you their best rates, or at least good ones, lenders will generally like to see you with a score in the 700s -- and the higher, the better. To see just how much your credit score matters, the table below reflects recent rates for someone borrowing $200,000 via a 30-year fixed-rate mortgage:

FICO Score

APR

Monthly Payment

Total Interest Paid

760-850

3.904%

$944

$139,766

700-759

4.126%

$969

$148,990

680-699

4.303%

$990

$156,434

660-679

4.517%

$1,015

$165,541

640-659

4.947%

$1,067

$184,183

620-639

5.493%

$1,135

$208,492

Source: MyFICO.com,as of early March 2017.

If your score was on the poor side when you initially got your mortgage, and you've improved it since then -- perhaps by paying off lots of bills on time, or paying off costly credit card debt in order to reduce your debt-to-income ratio -- you may be able to refinance at a meaningfully lower interest rate, even in an environment of rising rates.

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Step 5: What kind of new loan is best for you?

As you start the refinancing process, be sure you know what kind of loan you want. A refinancing is a do-over opportunity, and you don't have to just refresh the same kind of loan you originally took out. You can refinance into a totally different kind of loan.

For example, if you started out with an adjustable-rate mortgage (ARM), you may be facing gradually increasing interest rates over the coming years -- which will cost you more and more. You could refinance into a fixed-rate loan, locking in a low rate. (Even today's increased rates are historically very low.)

Alternatively, you might switch from a 30-year fixed-rate loan to a 15-year fixed-rate loan, in order to pay the loan off sooner and pay much less in interest. It will likely entail higher monthly payments, though, so be sure you can swing those.

If you're not very sure you can, there's a handy compromise: You could get a 30-year loan with no prepayment penalty and then pay significantly more than your required payment each month. That way, you can shave many years off the loan and avoid a lot of interest payments.

If you're getting pre-approved for a mortgage or a refinancing, make sure that your new loan doesn't include a prepayment penalty. If you're already in a 30-year mortgage with no prepayment penalty, you may not need to refinance at all -- you can shorten the life of your loan by just plowing more money into paying down your principal.

Meanwhile, if your current loan's monthly payments are too steep for you -- which might be the case if you have a 15-year mortgage now -- you might refinance into a fresh 30-year loan for the lower payments. Just know that that will be costing you a lot in interest over the long run, and that entering retirement with mortgage payments is not ideal.

If you know now that you won't be in your current home more than a few more years, you might refinance from a fixed-rate loan into an ARM with lower rates.

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Step 6: When will you break even?

Finally, consider the closing costs, as refinancings feature them, too. Closing costs can amount to 2% to 5%, or more, of the value of the loan -- so if you're borrowing $200,000, you might be forking over $5,000 or more. To figure out when you'll break even, divide the closing costs by how much lower your monthly payment will be.

If your costs are, say, $6,000, and you're saving $100 per month, divide $6,000 by $100, and you'll get 60. That means it will take 60 months (five years) before you'll break even. That's no problem if you expect to be in the home at least that long. But if you might be moving sooner than that, reconsider refinancing.

Interest rates are inching up now -- but that doesn't mean it's too late for you to refinance your mortgage. Use the steps above to see whether you might be able to save a lot through refinancing.

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