Who among us doesn't want a lower monthly mortgage payment, right? Well thanks to near-record low interest rates, more Americans have been able to refinance the old homestead. Still, a successful refi isn't just about getting a lower interest rate. There are several things you should consider before you dive into the process and sign on the dotted line. It's important to do your due diligence to determine whether refinancing your mortgage now is right for you, and if so, what you should do to properly prepare. Here are some questions to ask:
1. Why Am I Doing This?
There are several reasons to refinance a home mortgage. "[It] is a way for homeowners to potentially lower their interest rates and monthly mortgage payments, switch to a fixed-rate loan or use a portion of the available equity in their home to finance major expenses," emails Michelle McLellan, senior vice president and product management executive of home loans with Bank of America.
So be clear on why you want to refinance because that will affect how you go about it. If you want to reduce your monthly mortgage payments, then you'll want to lock in a low interest rate over the life of the loan (called a fixed-rate loan). On the other hand, if you want to pay off your loan as fast as possible, you'd probably want a loan with a shorter term with payments you can still afford. That might not be one with a fixed rate. If you mainly want to tap into your home's available equity, that type of refinance will have its own set of considerations.
"Just because you can get a lower rate, doesn't mean you should immediately refinance," says McLellan. "You may be paying a lower monthly mortgage, but you may have to also extend the life of your loan and cost you more in interest."
2. Does It Make Financial Sense?
Some people refinance to a longer-term loan because they're planning to stick around for a while, but that doesn't make sense for everyone, particularly people who want to retire soon-ish.
"Maybe you want to refinance to a shorter term and pay off the home faster," explains Tony Garcia, a Los Angeles-based market manager for Wells Fargo Home Mortgage. "Maybe I don't want to refi to a 30-year mortgage because I don't want to work until I'm 80. When I retire I want it paid off."
Garcia explains it can take time to really see the cost savings associated with refinance, so it's not the best route for people who don't intend to remain in that property for very long. "Let's say for example that a customer is looking to refi (to 4 percent) and they have a 5 percent interest rate," he says. "That 1 percent difference is great on paper, but if you're going to only be in the home for 12 months, that rate isn't going to be enough time to recoup the savings. If the costs are $3,000 to refinance, and you're only saving $200 a month and are only there a year, you might be better off ... not refinancing at all."
3. Do I Have Enough Home Equity?
It's easier to get a new loan if you have a least 20 percent equity in your home (equity is the difference between the outstanding mortgage and your home's market value). So, it pays to make sure you know what your equity amount is before proceeding. For instance, if your mortgage is $200,000 and your home is valued at $300,000, then your equity is $100,000, or 33 percent. Tools like those at Bank of America's Real Estate Center can provide a solid idea of your home's potential value.
4. What Is My APR?
Garcia says that consumers often fail to look at what the projected annual percentage rate (APR) of a loan is, in addition to the interest rate, which is a pretty big oops. APR includes the fees that you'll be holding the bag for, like origination fees or appraisal fees. "It's the true cost of the actual mortgage," he says.
You can calculate the APR by adding the fees and the interest on the loan and dividing that by the loan amount. Divide that answer by the term of the loan (how many days you have for the loan). Multiply that by 100 to get the APR. For instance, a 30-year fixed year loan with a rate of 3.75 percent has an APR of 3.834 percent. Most lending institutions (banks, credit unions etc.) will have a chart showing the loan rate next to the APR rate. Visit at least three different lenders to see what rates each are offering.
5. What's My Credit Score and Debt-to-Income Ratio?
Typically you need a credit score of above 760 to get the best mortgage rate. If your credit score is lower than that, you might have to pay a higher rate, which could determine whether it's worth it to refinance. You can find out your credit score in advance for free often through your credit card company or a service like Credit Karma.
Even with a great credit score, you might find yourself paying a higher mortgage rate if your debt-to-income ratio is also high. (Divide your total monthly recurring debts by your gross monthly income to get your debt-to-income ratio.) It should be less than 36 percent and housing payments should be less than 28 percent.
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