As a homeowner makes monthly payments on a mortgage, each payment typically contains a mixture of principal and interest. The interest is money paid to the lender with the principal portion reducing the homeowner’s outstanding balance on the mortgage. As the balance goes down, more of each payment will go towards the principal, although it’s a gradual process.
As the balance decreases, the homeowner has an increasing amount of equity in the home (given that the home’s value doesn’t decrease). Homeowner’s equity is the portion of the property that’s “free and clear,” what the owner owns without a mortgage on it—and, once the owner has a certain amount of equity in the home, then they may be able to borrow against it, such as through a refinance.
What Is the Average Cost to Refinance a Mortgage?
In April 2020, ClosingCorp reported on the average national mortgage closing costs for a single family home in 2019:
• When including taxes, the figure was $5,749.
• When excluding taxes, the figure was $3,339.
These figures included the following expenses:
• Lender’s title
• Owner’s title
• Settlement fees
• Recording fees
• Land surveys
• Transfer tax
And a few things to consider:
• Closing costs vary widely from state to state, with Indiana having the lowest average at $1,909 and the District of Columbia the highest at $25,800.
• Not all lenders charge the same in closing costs.
• Refinancing closing costs can be similar to when purchasing a home but there may be some differences.
What Are the Typical Equity Requirements?
Lenders typically want at least 20% of equity (80% loan to value) to exist for a refinance to take place, although that ratio is not universal.
Here’s an example of equity. If a home is worth $150,000 and the current mortgage loan is $100,000, then there is $50,000 in equity, with a loan to value ratio of 66.6% ($100,000/$150,000). This scenario, therefore, fits the typical loan to value parameter required by many lenders for a refinance to take place.
People refinance their mortgages for numerous reasons. They can include:
• They need cash, perhaps to do some home remodeling; this may be called a cash-out refinance;
• Rates are lower than when they bought the home and they want to take advantage of a lower rate; sometimes, the refinance may shorten the term of the mortgage with the borrower’s goal being to pay less interest over the life of the loan—and these scenarios are sometimes called “rate and term” refinances;
• Consolidating debt, perhaps balances on high interest credit cards; this is another example of a cash-out refinance.
To refinance, a homeowner takes out a new loan against a piece of real estate, pays off the current loan(s) on that property, and then, if applicable, uses the remaining funds for another purpose, whether that’s to consolidate credit card balances or to get a new roof.
Recommended: How to Refinance a Mortgage
In general, refinancing a mortgage comes with costs that are similar to purchasing a home. These costs vary from lender to lender—and what a particular lender charges a borrower may depend upon the loan amount among other factors. Borrower credit scores may play a role in the interest rate.
Role of Credit Scores
Having what lenders would consider a “good” score can help a borrower get a more attractive rate and, if the credit score has improved since the initial mortgage loan was taken out, that could be a reason to refinance all by itself. FICO® Scores can be checked here .
Experian provides insights into credit score ranges:
• Exceptional: 800 to 850
• Very good: 740 to 799
• Good: 670 to 739
• Fair: 580 to 669
• Very poor: 300 to 579
Experian notes that conventional lenders may approve applications with a FICO Score of 620 or higher, with ones in the mid-700s and above giving borrowers an even better shot of getting a low rate. Besides the credit score, lenders typically review other elements of a borrower’s history, including recent credit applications, track record of making payments on time, how much available credit is being used (known as a “credit utilization ratio”) and so forth. Major red flags can include bankruptcies and foreclosures.
Borrowers who see errors on their credit reports can contact credit bureaus to request corrections, which may help when refinancing.
A better interest rate is one way to save money over the life of the refinance loan. Another way to be cash savvy is to compare closing costs among lenders before deciding which one to choose for the refinance.
What Are Some Mortgage Refinancing Fees?
This is not intended to be a comprehensive list. Rather, it’s an overview of some of the more common fees charged during a refinance.
Loan Application Fee
Some lenders may charge this fee when a borrower applies to refinance. Sometimes, it’s paid upfront, although some lenders will waive the fee if the process is completed. Typically, if a borrower pays this fee and the application is turned down, this fee is not refundable.
Loan Origination Fee
Some lenders will charge a fee, perhaps 1% of the loan amount, to pay for their time while they investigate the borrower’s ability to repay the loan.
Lenders typically want to know the current value of the home to determine how much a person can borrow against it. There can be circumstances when they won’t require one on a refinance.
Credit Report Fees
A lender may decide to use data from multiple credit reports from different bureaus, although the FICO Score is the most commonly used. Fees charged for this item may vary, based upon a lender’s policies.
Title Search and Insurance
This search identifies liens on the property along with other issues with ownership, with the insurance covering the lender in case any problems arise after the refinance has taken place.
This covers the paperwork and processes involved in closing the loan.
Mortgage Points/Discount Points
Lenders can offer borrowers the ability to pay mortgage points at closing time to lower their interest rates. A point equals 1% of the money being borrowed. So, for example, a lender may be willing to lower the interest rate by 0.25% for each 1% of the loan amount that’s paid up front. If the refinance loan amount was $200,000, for example, a borrower under this arrangement could pay $2,000 for each point to lower the interest rate, which in turn could help save a significant amount of interest payments over the life of the loan.
When Is It Smart to Refinance?
This topic can be broken down into two questions:
• When can a borrower refinance a home loan?
• When does it make sense to do so?
In response to the first question, the borrower should check to see if a current mortgage agreement has a prepayment penalty. Credit Karma notes that, although it’s become less common to see this feature in mortgages since the 2008 housing crisis, they do still exist.
A prepayment penalty, as the name suggests, is a penalty that a borrower may incur when paying off the mortgage during the first few years—which can be included when refinancing the property during that designated timeframe. The amount and timetable of a prepayment penalty, if included in mortgage terms, varies by lender. And, if one is applicable, they can cost a borrower thousands of dollars.
If there is not a prepayment penalty involved, then the borrower can likely apply to refinance (although whether they qualify depends upon their financial circumstances and lender requirements).
Moving on to the second question, there are specific times when it may make sense to refinance. When considering whether a refinance is a good idea, think about the closing costs and calculate how long it would take to recoup them.
Here’s an example. Let’s say that refinancing to a lower rate causes a payment to go down by $100 a month. If closing costs were $3,500, then it would take 35 months to recoup the costs and start to see savings. If the borrower planned to sell the house in two years, then refinancing may not be the right strategy. If, however, the borrower intended to stay in the house, long term, it may be an idea to explore.
Other people may decide to refinance to shorten their loan’s term, say from 30 years to 15. Monthly payments may well go up, but a lower interest rate and a shorter term can help those borrowers pay less over the life of their loans. This loan amortization calculator can show how much interest may be saved.
Other people may decide to refinance, in order to switch their adjustable-rate mortgage (ARM) to a fixed-rate one. Someone might have originally taken out an ARM because of its low initial rate but now may want the security of knowing there won’t be future rate increases.
Yet another strategy is a cash out refinance where equity in a person’s home can be used to perform home repairs or consolidate high-interest debt. In some cases, this can be a great strategy; other times, the reduction in home equity may not be worth the trade-off.
Recommended: Guide to Buying, Selling, and Updating Your Home
Mortgage Refinancing With SoFi
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