How to Refinance a Mortgage

Javier Simon, CEPF, 2nd July 2019

When you refinance a mortgage, you take out a new loan to pay off the old one. This time, you aim for a lower interest rate and better terms. However, refinancing a mortgage can be a risky process. It’s important to be informed so you can make intelligent decisions throughout the process. It may also be a good decision to find a financial advisor who can guide you through the entire refi journey.

What to Know Before You Refinance

Some mortgage lenders charge hefty penalty fees if you pay off your mortgage early or if you use your home equity line of credit to refinance your original mortgage. This is calculated as the difference between the money you owe to your lender and the appraised value of the home.

These fees can stretch to thousands of dollars. So make sure you contact your lender to discuss any potential penalties for refinancing your mortgage.

Furthermore, you’d need a decent credit score to secure a new mortgage with a favorable interest rate and terms. So if yours can use a boost, you may want to take advantage of different ways to improve your credit score before refinancing your mortgage.

Below, we list some steps you can take to do so:

Shop for around for the best balance transfer cards to pay off credit card debt
Consolidate multiple student loans into one with a favorable interest rate
Use a budget calculator to see what expenses you can cut back on

But if you’re ready to move forward with the refinancing process, there are some steps you can take to do it the right way.

Understand Your Mortgage Payments

Before you sign anything, you’d want to be aware of how much you actually owe to your lender. By comparing what you’ve already paid of interest versus what you’d owe through a new mortgage, you can make better decisions around downsizing your debt.

You can use a mortgage calculator to dig into the different parts of your mortgage payments such as interest and property tax charges. This process can also help you decide if it’s a good idea to extend or reduce the term on the new loan. Switching to a 30-year-mortgage from a 15-year-mortgage can reduce your monthly payments. But you’d also pay more interest for a longer period of time before you can truly call your home yours.

Shop Around for the Best Mortgage Rates

These days, it’s easy to surf the Web to compare mortgage rates. To help you get started, we also published a report on the best refinance mortgage lenders. You can expect a loan estimate from each lender you contact within three days of providing your initial paperwork.

With that said, have a checklist ready and make sure you gather the following documents:

Driver’s license, passport and other proof of identity and residence
Recent pay stubs with income-to-date information
Last two tax returns
Statements from banking, savings and investment accounts
Record of retirement savings and other assets
Profit and loss statements if self employed
Record of freelance earnings (if applicable)

Know the Real Costs of Refinancing a Mortgage

Don’t just focus on the loan estimates from different lenders. You should always keep your eyes peeled for hidden fees and charges. These typically stretch from about 3% to 6% of your new outstanding loan balance. Fees can include the following:

Application fees
Appraisal fees (unless you bought your house very recently)
Document processing fee
Underwriting fees
Title research fee
Recording fee
Tax transfer fee
Credit report fee
Insurance

Keep in mind that if you took out an initial loan that was more than 80% of your home’s value, you’re likely paying private mortgage insurance (PMI). Unlike traditional insurance that covers disasters like fires, PMI exists for the benefit of the lender to ensure your loan get paid in the event of a default.

Mortgage Refinancing Options

Depending on your goals and needs, certain types of mortgage refinancing options may suit you. Below are common strategies you should consider:

Rate-and-Term Loans

These types of mortgages allow you to change your interest rate or the amount of time you’re allowed to pay off the loan. For example, you can move from a 15-year fixed-rate mortgage to a 30-year-fixed-rate mortgage or vise versa. Or you can switch from a fixed-rate mortgage to an adjustable-rate mortgage (ARM). The latter better suits the borrower during a climate of low interest rates. With that said, keep your eyes on where the prevailing interest rate needle is moving and how that may affect your monthly payments.

Cash-Out Mortgages

When you “cash out” on a mortgage, you take out a new loan that’s larger than what you need to pay off the old one. You get the difference in cash.

For example, let’s say you’ve spent the last few years making timely payments on a home that has increased in value. You now owe $70,000 for a home worth $250,000. Suppose you needed $40,000 for remodeling projects. So you decide to refinance a mortgage for $110,000 (the balance you owe plus the amount you need for projects). That loan would pay off the first mortgage leaving you with the difference of $40,000 in cash.

This cash-out strategy works only when you use the refund wisely. For example, funneling some or all of that money into remodeling your home can boost the home’s value. Eventually, you may sell your home for more than you borrowed to pay for it. Or you can ease some financial burdens by using the cash out to pay high-interest debt such as credit card payments.

Remember, your lender isn’t just giving you a nice bonus. The cash out means you’ll have more to pay back in the long run. The key is to make sure you use it to get an overall stronger financial foothold and to maintain that status by making timely payments.

Keep in mind, however, that these options may require stricter approval terms because of the amount of risk the lender is taking when giving you a loan plus cash.

Programs That Help Lower Mortgage Payments

Some government-run programs help homeowners lower their monthly payments or secure better terms. Below are some examples.

FHA Streamline Refinancing

Many government-backed refinance programs allow you to streamline the process of taking out a new loan. This means you skip through much of the paperwork needed to secure a conventional loan.

If you’re currently paying off a Federal Housing Administration (FHA) loan, you can refinance it with a new one. You don’t need to provide documentation of income, bank account statements or credit reports. You also skip the appraisal process. Instead, your FHA-backed lender assumes your home is valued at the price you borrowed to pay for it.

To qualify for an FHA streamline refinance loan, your loan must be at least 210 days old and you need to prove timely mortgage payments. In addition, you need to demonstrate the new loan will drop your mortgage payments by at least 5%.

In addition, your new loan must provide you with a net tangible benefit in order to qualify. This means that your new loan must put you in a better financial situation. You generally must reduce the combined rate by at least 0.5%. The combined rate equals your interest rate plus the mortgage insurance premium (MIP) rate.

FHA loans usually carry much lower interest rates than conventional loans. Upfront closing costs stand at about the same and can range from around $1,000 to $5,000.

USDA Streamline-Assist Refinance

If you’re paying off a loan backed by the United States Department of Agriculture (USDA) Rural Development program, you can refinance it into a new USDA loan.

You’re allowed to bypass several requirements typically reserved for taking out conventional mortgages. For example, you don’t need to provide documentation of income or your credit report. You also don’t need to put your home through an appraisal.

Still, you need to prove you’ve made timely payments on your current USDA loan in the past 12 months. Your lender may pull a credit report or ask for light documentation to verify. You also need to pay an upfront fee totaling 1% of the new loan amount as well as a 0.35% annual fee. Closing costs roll over into the new loan amount.

Your income must meet current maximums set by the USDA depending on the location where your home stands. You can still qualify for a refinance loan even if the area where you live in is no longer in a USDA-designated area or if your home is “underwater.” To finalize a USDA streamline-assist refinance loan, your new monthly payment must drop by at least $50 including principal, interest and guarantee fees.

In addition, you can take out a standard USDA Streamline Refinance loan. The major difference between this loan and a USDA Streamline Assist is that closing costs can’t roll over into the new loan amount. However, the upfront fee may be rolled into the new loan amount. In addition, you need to provide proof of income and meet debt-to-income (DTI) levels set by the USDA.

With a non-streamlined option, you’ll need to provide additional paperwork and put your home through the appraisal process. Some borrowers take this route when they find value in refinancing but don’t meet the $50 monthly drop rule.

Interest-Rate Reduction Refinance Loans (IRRRL)

If you’re paying down a VA loan, you can refinance it into an Interest-Rate Reduction Refinance Loan (IRRRL) with a lower interest rate and monthly payment. Your current mortgage doesn’t need to be tied to your current residence in order for you to qualify.

However, you may need to maintain a certain credit score. Each lender sets its own parameters, but a credit score of about 580 to 640 may help you significantly reduce your interest rate. Generally, you’ll also need to maintain a certain debt-to-income ratio of at least 41%, but some lenders let your DTI reach to around 55%.

You also typically need to prove you’ve made timely mortgage payments in the past 12 months. You can roll fees over into the new loan amount.

An IRRRL works similarly to a rate-and-term loan.

VA Cash-Out Refinance Loan

To obtain a cash-out refinance through the VA, you’ll need to maintain a particular minimum credit score and put your home through an appraisal process. The home you’re refinancing must also be your primary residence.

Qualifying borrowers can also take the cash-out route to refinance a conventional mortgage into a VA loan.

If you’re a military service member who meets VA loan requirements, you may be able to refinance a conventional mortgage into a cash-out VA loan. Below are some of the basic qualifications:

Veteran with at least 90 to 181 days of continuous service
Active duty service member for at least 90 continuous days
National Guard or Reserve member for at least six years or honorably discharged member
Un-remarried surviving spouse of veteran or service member who died in line of duty or from service-related incident

Fees for VA Refinance Loans

In addition to applicable origination and closing costs, you need to cover a VA funding fee. That rate equals 0.5% of the loan amount for IRRR loans. Cash out options carry fees ranging from 2.15% of 3.3%, depending on whether the new loan is your first VA loan.

If you served in the National Guard or Reserves and you’re taking out your first VA cash-out refinance loan, the fee measures 2.4%. The VA funding fee is waived if you have a service-related disability or if you are the surviving spouse of a service member who died in the line of duty or from a service-related injury and you have not remarried. You can also roll over closing costs into the loan amount except for cash-out loans. However, you may cover these payments with the cash-out money. Also remember that VA loans never require PMI.

Recap: Refinancing Your Mortgage

After you decide which type of refinance option is right for you, shop around to find the best mortgage rates and loan terms. Ask the lenders you contact all about the fees and overall costs of refinancing. Make sure you calculate closing costs you may encounter.

In addition, you should try to boost your credit score before you sign anything. Remember, a higher credit score helps you secure the best interest rates and terms for the new loan. Making any corrections to your credit report can only help.

Also, make sure your current loan doesn’t have any prepayment penalty. These costs can measure up to about six months’ worth of interest payments due in one shot. Government-backed loans don’t usually carry prepayment penalties.

In addition, you can benefit from researching recent home sales in your neighborhood to estimate the true value of your home.

But after you land a refinance option that meets your needs, determine if you can and should lock your interest rate. This obviously won’t be an option for all loans, but it can help especially in a shaky interest rate environment.

Once you’ve made a decision, you’ll sign the necessary paperwork and your lender will give you a closing disclosure form. Your loan will go on record and you’re ready to start a new on a loan with significantly better rates and terms.

Tips for Refinancing a Mortgage

Make sure the long-term savings of mortgage refinancing outweigh all costs. You win only when that new loan carries significantly better rates and terms. So make sure that you’re saving in the long run and factor in all fees and calculate the property taxes for your area.
Get all your documents together. Mortgage refinancing requires most of the paperwork you needed to take out your old mortgage (and sometimes more). So have files ready to prove your identity, employment, income, assets, etc.
Refinancing a mortgage can lead to many risks you want to avoid. So consider working with a financial advisor through this process. You can use our financial advisor matching tool to connect with up to three professionals in your area. We’ve vetted every advisor on our platform. The tool also gives you free access to their profiles, so you can compare their qualifications before deciding to work with one.

JAVIER SIMON, CEPF®

Javier Simon is a banking, investing and retirement expert for SmartAsset. The personal finance writer’s work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society for Advancing Business Editing and Writing. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children’s Miracle Network Hospitals and the National Center for Missing and Exploited Children.