At some point, everyone looks at their budget and wonders if there are ways to ease their cash flow.
Sure, you can cut some of the small stuff from your spending, but that has limited impact. One of the biggest things you can do to reduce your monthly obligations and improve your cash flow is to refinance your mortgage.
Depending on the size of your mortgage and the interest rate you end up with, it’s possible to save hundreds each month. Here’s what you need to know about the mortgage refinance process.
What is mortgage refinancing?
When you refinance a mortgage, you replace your current home loan with a new lower-interest mortgage. Your new mortgage lender pays off your original mortgage on your behalf, and you start making monthly payments to them.
In addition to getting a lower interest rate, you might also be able to extend the loan by a few more years. This could lower your monthly payment, though you may pay more in interest over the life of your mortgage.
Your mortgage refinance is all about getting a new home loan, so you have the chance to see totally new terms and fit your mortgage to your financial situation and your life.
What are mortgage refinance requirements?
Refinancing your mortgage means getting a new mortgage on your home — so all of the requirements attached to a mortgage are likely to apply. There are also additional requirements when you refinance. Here’s everything you’ll need to consider.
1. Credit score
In order to refinance your mortgage, you need to have good credit. You will get the best rates when you have a credit score of at least 740. However, you can still get reasonable mortgage rates with a score between 700 and 739.
Before you apply to refinance, check your credit report. Look for inaccuracies and fix mistakes. If you have lower credit because of past mistakes, make a plan to fix it. Find out what’s holding you back. Whether it’s a high credit utilization or missed payments, work to improve your credit score before submitting your application.
As with any loan, you need to show proof of income. This might include past pay stubs and the last two years’ worth of tax returns. If your income isn’t enough to meet the lender’s debt-to-income ratio requirements, you might not be able to refinance.
Depending on the lender, you might be able to get a loan with up to 43 percent debt-to-income.
3. Loan-to-value ratio (LTV)
How much you owe on your home relative to your house’s market value matters. In some cases, lenders want to see that you have at least 20 percent equity in your home after the refinance. That means that after you refinance, your LTV should be at least 80 percent.
Let’s say your home is worth $250,000 on the market. You could refinance up to $200,000, which is 80 percent of your home’s value. If you owe $175,000, it shouldn’t be a problem to refinance your loan.
Depending on the lender, you might even be able to refinance for more than you owe and “cash out” some of the money. Maybe you decide to refinance $190,000. You meet the LTV requirement and you get the extra cash ($15,000) beyond the balance of your mortgage.
In some cases, you can refinance for more than your home is worth — some lenders will let you refinance up to 125 percent of your home’s value. If your home lost value and it’s only worth $165,000, you might be able to refinance up to $206,250. However, you might not get the same favorable terms.
It all depends on the lender, your situation, and what the lender is willing to do.
4. Second mortgage on the house
When I refinanced my home in 2012, there was a small second mortgage on the house. If you have a home equity loan or HELOC on your property, it might make it harder to refinance. For those with a lower LTV, it’s sometimes possible to refinance a large enough amount to pay off the second mortgage as well as the first mortgage.
In my case, the home had lost value and that wasn’t an option. However, because the second mortgage was relatively small, I was able to pay it off as a condition of the refinance. Depending on the lender, you might not be able to refinance if a second mortgage is involved.
How much does it cost to refinance a mortgage?
Your mortgage refinance is a new loan, and it might cost you. Some lenders are willing to waive origination fees when you refinance. However, just because a few fees are waived doesn’t mean all of them are.
You might end up paying closing costs. Trulia’s real estate blog estimated that you can expect to pay about 1.5 percent of your principal loan amount in closing costs when you refinance.
In the case of a $175,000 refinance, your closing costs would be $2,625, assuming 1.5 percent of your loan amount.
How much could a mortgage refinance save you?
How much refinancing saves you depends on your situation.
Using a calculator from the National Association of Realtors (NAR), you can get an idea of the impact of refinancing. Say you got your original loan of $200,000 in 2010. Now you owe about $175,890. Refinancing adds another seven years to your mortgage debt.
In this scenario, you only save $2,698 in interest. That’s barely enough to cover your refinancing fees.
However, your monthly payment will decrease by $248 per month. So if you are looking to improve your monthly cash flow, refinancing can make sense, even if the interest savings aren’t as big. Refinancing can mean more breathing room in your budget.
Refinance to a shorter term for bigger interest savings
If you’re more interested in getting out of debt sooner and saving big bucks on interest, consider refinancing to a 15-year term.
You end up paying an extra $189 each month. However, you save nearly $70,000 in interest over the lifetime of your loan, according to the NAR calculator.
Refinancing your mortgage to a shorter term is all about saving money overall because of the lower interest rate and the shorter payment term. In general, the less time you spend paying interest on your debt, the more money you save in the long run.
Homeowners who can handle the higher monthly payments can benefit from refinancing to a shorter term.
Once you lock in that higher payment, though, you need to be careful. A change in circumstances could mean that you can’t make your higher mortgage payments. That can put your home at risk.
Some borrowers figure out how much their payments would be with a 15-year loan, but refinance to a 20-year or 30-year loan. They make the higher payments to super-charge their debt pay down, but if they run into a sticky patch, they can revert to the required payments to free up cash flow.
What if you want to cash out?
Perhaps you decide to refinance because you want a lower interest rate and payment, plus you hope to get an extra $15,000 in cash. Your home has increased in value since you bought it, so there’s room for you to cash out and still meet the 80 percent LTV requirement.
Be aware that you might not get as low an interest rate when you cash out. A cash-out refinance is considered riskier than a straightforward refinance.
With this cash out, you save money each month. It’s not as much as just refinancing, though. You end up with an extra $145 in your budget. That eases your cash flow issues, and you end up with a $15,000 lump sum in cash.
However, you no longer end up with a net interest benefit if you refinance to a 30-year loan for the monthly savings. Instead, you wind up paying an extra $23,016 in interest.
A bigger, longer loan means you pay more in interest over time. Spreading it out means your monthly payment is less, though. Smaller payments can ease your budget constraints, but you will pay tens of thousands of dollars extra over the life of your loan as a consequence.
But if your aim is to get cash out of your home and save on your monthly payment, the extra interest cost might be worth it — especially spread out over several years.
Should you pay mortgage points?
Finally, you also need to figure out if you should pay points. The points you pay for refinancing might be tax-deductible, and they can lower your interest rate by a little bit.
If you are willing to pay one percent of your mortgage amount, you can see a reduction in your interest rate. This is sometimes called “buying down” your mortgage. It results in a lower interest rate that can save you money over time.
With a mortgage amount of $175,890, you can expect to pay about $1,760 for each reduction of 0.25 percent. You can roll these into the cost of your loan as well. Paying one point means higher costs, but a lower mortgage rate of 3.61%.
In this case, you end up saving only $864 over the life of your loan. You would need to make a bigger upfront payment to reduce the interest by more. If you aren’t planning to stay in your home long enough to pay off the mortgage, you might not recoup the upfront costs at all.
How to get started refinancing your mortgage
If you want to refinance your mortgage, start by getting a mortgage rate quote.
Compare different possibilities. Realize, though, that the quote you see is based on the best available rates. Depending on your credit and other factors, you might not qualify for that rate. But it gives you an idea of what you could save.
Next, contact between three and five lenders with low rates to talk about the specifics of your situation. This gives you a better idea of what to really expect.
Find out what paperwork you need to submit. You need all the paperwork associated with a mortgage, including:
- Identifying information (names, birthdates, addresses, and Social Security numbers of all the applicants)
- Asset information, including bank statements and retirement account statements
- Pay stubs
- Tax returns
- Documentation of your current mortgage
Some companies allow you to submit most of your paperwork over the Internet. During my refinance, I completed most steps online. The only thing I had to do was sign the new loan papers in the presence of a notary.
Does it make sense to refinance your mortgage?
Refinancing can make sense in the long run. How you go about it, though, can affect your total savings. Before you refinance, think about what matters to you and what your goals are.
If you’re just looking for better cash flow with a side of potential overall interest savings, refinancing to a 30-year loan can make sense. But if you want serious interest savings, a shorter-term refinance might be the way to go.
Once you realize what matters to you with your refinance, you can decide the best way to approach the situation.