Homeowners may be well aware of the concept of refinancing, but they often need help with recognizing when it is the right time to refinance. There are some simple refinancing rules that will help you determine not only whether you can benefit from refinancing, but how to make the most of the opportunity.
Although people are usually grateful for any chance to save money by refinancing, making the most of the opportunity is important because there are closing costs involved. You have the best shot of offsetting those costs if you can derive the maximum benefit from refinancing the first time, so you don't have to do it again a few years down the road.
How do you know when you are ready to refinance? These refinancing rules should help you tell whether you have gone through the necessary steps to make the most of the opportunity:
Get Your Credit in Shape First
Check your credit score and make sure there are no issues on your credit report that need to be addressed – either mistakes that can be cleared up or deficiencies you can rectify. This is not simply a matter of getting approved for refinancing. The best interest rates go to people with the best credit, so taking the time to improve your score before refinancing can pay off in the form of lower interest costs for years to come.
Refinance Before Changing Jobs
You might think that taking a higher-paying job would improve your chances of getting approved for refinancing, and depending on the circumstances, it might. However, if the pay difference is relatively modest, a job change just before refinancing could cost you. Lenders want to see stability, and a recent job change could be seen as a risk. That perceived risk could translate to higher interest rates, or if you did not have a stable job history prior to the recent change, it could result in getting your refinancing application denied.
Shoot for at Least 20 Percent Equity
The lower the value of the new mortgage relative to the value of your property, the less risky the loan is to lenders. Building up a solid equity cushion before refinancing can pay off in helping you lower mortgage insurance premiums or avoid them altogether, and could also earn you a lower interest rate.
Don't Refinance Like a First-timer
Programs like FHA mortgages are great for first-time home buyers because they help people with limited credit histories qualify for a home loan. However, if you have built up a good credit record and raised your income since first buying your home, you may now qualify for a conventional mortgage. This might give you access to lower interest loans that don't require mortgage insurance.
Look into Shortening Your Term
Generally speaking, the trade-off is that shorter mortgages involve steeper monthly payments but save you in the long run by offering lower rates and fewer years of interest payments. By the time you refinance, you may have lowered your mortgage balance and raised your income enough for the higher monthly payments of a shorter mortgage to be affordable, thus allowing you to benefit from the long-term savings.
Factor in Closing Costs
Small drops in mortgage rates are not enough to justify refinancing because there are closing costs involved. Use a refinancing calculator to figure out whether the drop in interest rate is enough to offset the upfront costs over time, and check how long you would have to remain in the house for the interest benefit to offset the costs.
Check for Prepayment Penalties
Some mortgages carry penalties for early repayment, including refinancing. Before you refinance, check your existing mortgage for such penalties. Often, these penalties expire after a designated amount of years, so you might be able to avoid them if you time your refinancing accordingly. If not, then the prepayment penalty should be included along with closing costs as a hurdle that your interest rate savings would have to overcome in order for refinancing to be worthwhile.
Play the Field
If you have a good repayment record, your current lender might be very receptive to refinancing your mortgage, but don't limit yourself to considering only your existing lender. Shop around to see who offers the best rates and fee terms.
Remember, saving money by refinancing is good, but refinancing when you are prepared to make the most of the opportunity is what will allow those savings to really pile up in the years ahead.