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How to Refinance a Mortgage

If mortgage payments are eating away at your income, you may find some relief through refinancing your home loan. When you refinance a mortgage, you basically take out a new loan to pay off the old one. This time around, however, you aim for a lower interest rate and better terms.

Homeowners refinance their mortgages for various reasons including lowering their interest rates and monthly payments, increasing or reducing the amount of time they have to pay off their mortgages or getting some cash to remodel a home or pay off other debt.

However, taking out a new mortgage may come with new fees and loan terms. So make sure you’re refinancing for the right reasons. If you’re looking to lower your mortgage rate, for example, aim to shoot it down by at least two percentage points. Otherwise, fees could overshadow your savings in the long run.

How to Refinance Your Mortgage

Applying for a refinance is very similar to applying for your initial mortgage. It requires an application, paperwork and processing, the same as your first loan. One thing to keep in mind is you don’t have to refinance your mortgage through your original lender. You can shop around and find a new lender for your refinance.

Most refinance loans require much of same paperwork you used to take out the first loan. You’ll want the following documentation at hand:

  • 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 investing accounts
  • Record of retirement savings and other assets
  • Credit report
  • Profit and loss statements if self employed
  • Record of freelance earnings (if applicable)

How Much Does Refinancing a Mortgage Cost?

Within a few days of receiving your initial documentation, each lender should give you an estimate of what you’ll pay. 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 lower interest rate environments. 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.

Cash-In Refinance

With these loans, you pay a sizable chunk off your current mortgage in order to improve your loan-to value ratio (LTV). Your LTV equals your current loan balance divided by the home’s value.

Most major banks tend to provide better rates on refinance loans when your LTV stands at around 80% or lower. However, you need to make sure that the lower interest rate will benefit you in the long run especially because you’re required to pay off a large amount to get it in the first place. In order to reach an 80% LTV on a $400,000 house, you’ll need to break the mortgage down to $320,000. That means you need to cough up $80,000 in cash.

But what if your lender offers to bring your interest down from 6% to 4% on a 30-year fixed-rate mortgage. In this case, your annual interest payments drop from $24,000 to $12,800. If you divide the difference, or $11,200, by the amount you’re supposed to pay in cash ($80,000), your rate of return is 14%. For some investors, this is considerably good compared to average market returns.

Moreover, you will regain the $80,000 in interest savings in about seven years (Cash-in amount divided by annual savings in interest or $80,000 / $11,200).

With that said, cash-in refinances typically work in your favor only when you plan to stay in your home for at least the life of the loan.

The answer to whether you should take the cash-in route, however, ultimately depends on your individual situation. So ask your lender all about how this decision can benefit you. You can use a mortgage calculator to compare different rates and visualize how a refinance would affect your financial status in the long-term.

Programs That Help Lower Mortgage Payments

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

HARP Loans

How to Refinance a Mortgage

The Home Affordable Refinance Program (HARP) aims to provide relief to homeowners struggling to make their mortgage payments. However, HARP only extends up until Dec. 31, 2018.  Plus, you won’t qualify for one if your current mortgage was issued after May 31, 2009.
Your current mortgage also must be backed by Fannie Mae or Freddie Mac. These government-sponsored corporations are huge in the housing world, so they’re most likely behind your mortgage even if you’re making payments to a bank, credit union or online lender.

HARP looks to lower your monthly payments, but you also need to demonstrate you’ve been keeping up with your mortgage responsibilities. If you’ve missed a payment for more than 30 days in the past six months, you may have some trouble qualifying for a HARP loan. But to cut you some slack, HARP ignores one late payment in the last year.

Your eligibility doesn’t rely on your credit score, and closing costs roll over into the mortgage balance. In addition, you can secure a HARP loan even if your current mortgage is underwater. This means you owe more than what your house currently values at.

In addition, you can qualify for a HARP loan even if your current LTV is 80% or more. HARP loan qualification also requires considerably less paperwork than you typically need to secure a conventional loan.

If you land a HARP loan, the terms function similarly to a rate-and-term refinance mortgage. You can lower the interest rate, change the interest structure, alter the life of the loan or a combination of these depending on your qualifications.

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 as you would for a HARP loan. 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 However, FHA loans issued before June 1, 2009 could earn you a reduced refinance MIP of 0.01% upfront and 0.55% a month.

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) 
How to Refinance a Mortgage

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. Fees can be rolled 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 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.

Steps to Refinance 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 meet all about the fees and overall costs of refinancing.

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 help, too.

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.

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 anew 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. Refinancing is basically paying off your old mortgage with a new one. 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.
  • If you’re getting a cash out refinance loan, make sure the money is used to increase your home’s value or put you in substantially better financial standing. Remember, you owe that cash back.

Photo credit: ©iStock.com/courtneyk, ©iStock.com/Bill Chizek, ©iStock.com/Vgajic

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.
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