Refinancing involves applying for a new home loan to replace an existing one. There are many reasons why homeowners refinance their mortgages. For example, some refinance to take advantage of a lower mortgage rate and reduce their monthly payments, whereas others refinance to convert an adjustable-rate mortgage to a fixed-rate mortgage. Refinancing also makes sense when switching from an FHA mortgage to a conventional mortgage, and vice versa.
But although replacing an existing mortgage has its benefits, if you don’t understand how refinancing works, you might be skeptical and believe common misconceptions about this process. This is a big decision, so it’s important to separate fact from fiction.
Some homeowners never refinance because they think they need at least 20% equity to qualify. It’s true that a traditional refinance requires a minimum of 20% equity. But due to an increase in the number of underwater mortgages in recent years, it’s now possible to refinance a mortgage when you owe more than the property’s worth.
If your mortgage is owned by Freddie Mac or Fannie Mae, you might qualify for refinancing under the Home Affordable Refinance Program (HARP). This program helps homeowners with little or no equity refinance their mortgages and receive more favorable terms. Initially, HARP allowed refinancing with a loan-to-value (LTV) ratio of up to 125%. Currently, there’s no maximum loan-to-value cap if the new loan is a fixed-rate mortgage. If the new loan is an adjustable-rate mortgage, the LTV cannot exceed 105%.
Since this program is set to expire on September 30, 2017, talk with a mortgage lender to discuss eligibility. Additionally, you can ask about FHA loans if you don’t have 20% equity. Some FHA loan programs allow refinancing with as little as 3.5% equity.
The more home equity you have when refinancing the better. If you refinance without 20% equity, you may have to pay private mortgage insurance (PMI), which protects the lender in case you default.
Refinancing isn’t without expenses. Because you’re applying for a new home loan, you are responsible for paying mortgage-related costs. You don’t need to give the bank another down payment, but you will need to pay the closing costs, which can be 2% to 5% of the mortgage balance.
The good news is that lack of cash doesn’t prevent refinancing. Some lenders give borrowers the option of wrapping the closing costs into the new loan. This is a convenient feature. However, be mindful that including closing costs in the mortgage decreases your equity and increases the mortgage balance.
Having an existing mortgage and making timely monthly payments doesn’t automatically qualify you for refinancing. Since you’re creating an entirely new mortgage, you’ll have to repeat the application process. What does this mean exactly? Basically, you’ll submit a new home loan application and provide the lender with supporting documentation, such as your paycheck stubs and tax returns from the past two years. The lender also checks your credit report.
If your income hasn’t changed or if your income has increased since getting the original mortgage, you might not have problems refinancing the mortgage. But a decrease in your personal income since qualifying for the original mortgage could prevent refinancing, especially if the new monthly mortgage payment exceeds 28% to 31% of your current gross monthly income. Also, if your credit score has dropped since getting the original mortgage, this could also cause a lender to reject your home loan application, or you might receive a higher mortgage rate.
Some people also put off refinancing because they don’t want to start over with a new 30-year mortgage term. But while resetting the clock at 30 years is an option, it’s not the only one. There’s also the option of refinancing and choosing a mortgage term of 10, 15, or 20 years. To illustrate, let’s say you’re already 10 years into a 30-year mortgage. Rather than refinance for another 30 years, opt for a mortgage term of 20 years (or less). For that reason, you can take advantage of more desirable mortgage terms while sticking to your original payoff schedule.
