How does refinancing work?
Remember what it was like to apply for your current mortgage? Refinancing is basically the same. You find a great rate, then apply and submit documents that verify important parts your finances, including:
- Employment and income information
- Information about your existing debts, including your current mortgage
- Amount of equity you have in your home
If you’re a more qualified buyer, meaning your income and credit score are high and your debts are low, you’ll get better rates than if you make less and owe more. (This is referred to as debt-to-income ratio, or DTI for short. The lower the DTI you have, the better.)
When you refinance, your new loan pays off your current mortgage. That new loan is now your only mortgage debt, and you make payments until it’s paid off, or until you refinance again.
“Remember what it was like to apply for your current mortgage? Refinancing is basically the same.”
Benefits of refinancing
Before you think about how to refinance, you should know what you want to get out of it. Here are some of the potential benefits:
You can cash-out your equity
If you’ve been making mortgage payments for a while, you probably have equity built up in your home. It’s the difference between your home’s value and the amount you still owe on your mortgage.
When you refinance, you can choose to turn some of that value into cash. In this type of refinance, you’ll borrow more than you currently owe, then receive the difference in cash and pay it back as you repay the new mortgage. This is called a cash-out refinance.
Cashing out your equity can be a great way to fund home improvements and additions, especially if those improvements increase the value of your property.
“By refinancing when interest rates are low, you can save money for years to come.”
You can lower your rate
Interest rates have probably gone down significantly since you took out your mortgage. (Rates reached historic lows during the COVID-19 pandemic and, at the time of this writing, they’re well below where they’ve been in past years.
By refinancing when interest rates are low, you can save money for years to come. Also, if you switch to a fixed-rate mortgage, you can lock in current low rates and keep paying less interest even if market rates go up.
You can pay less per month, and less overall
A lower interest rate often means lower monthly payments, especially if you don’t shorten your loan term. In some cases, you can even save thousands over the life of your loan.
Just look at this data from the National Bureau of Economic Research (NBER):
Savings can be even greater with a bigger difference in interest rates. For example, NBER estimated that if someone refinanced from a 6.5% interest rate to a 4.5% interest rate, they’d save more than $80,000 on average. If they refinanced to 2020 historic lows of 3.35%, they’d save about $130,000.
You can consolidate debt
If you have a mortgage and a home equity loan or line of credit (HELOC), refinancing can combine those two loans into a single payment. This is an especially attractive option if the interest rates on your existing mortgage and your home equity loan are higher than the rate you can get for a refinance.
You can also use a cash-out refinance to pay off high-interest debts like credit cards or student loans. The interest on debts like those can be five times higher than a mortgage rate, especially at current levels.
Comparing rates: The key to getting the best deal
Once you’ve chosen to refinance, take some time to find the best possible interest rate. Here at Lower, we’ve made comparing simple—not only do we share our refinance rate (updated daily) but you can also see how it compares against the Bankrate national average rate, and other major lenders.
You can bring your interest rate down even more by strengthening your finances. Here are some tips to get you started:
1. Pay down credit card balances
Part of what drives your credit score up is your credit utilization rate. That’s the percentage of your approved credit that you use, divided by the amount of credit you have available. For example, if you have two cards with a combined limit of $5,000 and you have a balance of $1,000 on one and $500 on the other, your credit utilization rate is 30%.
You want your credit utilization rate to be under 30% before you apply for refinancing. If possible, try to get it under 10%. Pay down any balances you can. You can keep using your cards, but don’t let that add to your balance. Pay off what you spend at the end of the month.
“You can keep using your cards, but don’t let that add to your balance. Pay off what you spend at the end of the month.”
2. Check your credit report for errors
Creditors and credit bureaus make clerical mistakes just like anyone else, and you don’t want those mistakes to bring down your credit score.
Anyone can get a free copy of their credit report once a year from each of the three credit reporting bureaus. Request your copy at AnnualCreditReport.com and check for errors. It only takes a few moments and can save you a lot of money.
3. Ask about term-matching
Refinancing means you’re starting a new loan. That can mean you’re paying off your loan for longer and, in the end, possibly paying more in interest. For example, if you currently have 20 years left on your 30-year mortgage and you sign another 30-year mortgage, you’re adding on 10 interest-accruing years to your payment plan.
In some cases, you can shave off those extra years by asking your loan company to match your existing term without increasing your interest rate.
First steps for refinancing
Ready to start refinancing your mortgage? Here’s what you need to do first.
Step 1: Set your goal
Do you want to take cash out? Or just change your rate or term? Knowing the difference will be important when speaking with your loan advisor.
Step 2: Select your lender
Finding a lower rate is important. Here at Lower, we make it easy to see our current refinance rate (updated daily) and compare rates from other major lenders.
Step 3: Calculate your break-even point
When you refinance, you’re getting a new mortgage, which comes with its own closing costs. But you can still save a lot of money. To figure out how long it will take for your refinance to pay for itself, divide your costs by your total monthly savings. For example, if you’ll pay $2,000 and save $100 a month, your refinance will pay for itself in 20 months. The great part is—your refinance costs will most likely be figured into your new loan, and your new, lower mortgage payment will update as soon as your loan closes.
Crunch those numbers for each of your quotes to find out which will start paying for itself faster. Use this information to help you choose a loan.
The takeaway
Refinancing your mortgage can save you money, both on your monthly payments and over the life of your mortgage. You’ll save the most by keeping your finances strong and your credit score up. Work on paying off any debts you can. That way, once you’re ready to apply, you’re set up to get the best refinance rates possible!
Ready to get started? Check out Lower.com.
Want to get a second opinion on your refinance? Just get in touch.
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