Historically low mortgage rates have many homeowners wondering whether they should refinance their loans for a first time or even a second or third time.
“People in the D.C. area refinance often, partly because the high cost of housing means that a small change in rate can make a big difference in your monthly payments,” says Patrick Cunningham, a vice president and partner at Home Savings and Trust mortgage in Fairfax.
Cunningham says many people refinance to eliminate their private mortgage insurance (PMI) payments, either because they have more home equity or want to take advantage of a lender-paid PMI program. Other common reasons to refinance include pulling out home equity for college tuition, debt consolidation or to buy a second home, or when the owners are divorcing, Cunningham says.
“Home values are up in this area, so people who couldn’t refinance two years ago can often refinance now,” says Doug Benner, a senior loan officer with 1st Portfolio Lending in Rockville.
Benner says most people refinance to reduce their payments or to shorten a loan term from a 30-year loan to a 20- or 15-year loan. Interest rates are lower for shorter-term loans than for 30-year, fixed-rate loans. Depending on the borrower’s current interest rate and loan balance, payments could be similar on a shorter loan term while shaving years off the loan and saving thousands of dollars in interest.
Cunningham says Federal Housing Administration borrowers are opting for an “FHA Streamline Refinance” because new FHA loans have reduced annual mortgage insurance premiums from 1.35 percent to 0.85 percent of the loan balance, and these loans can be closed without any cost to the borrower.
However, refinancing doesn’t make sense for every homeowner. If you plan to move in less than one year, the cost of refinancing outweighs the benefits, and even a no-cost refinance may not make sense because of the time and paperwork required for refinancing, Benner says.
He says that in many cases, particularly for loan balances above $350,000, borrowers will have a true no-cost loan because the lender can provide a credit to pay closing costs. More commonly, Cunningham says, borrowers pay closing fees on “no-cost” loans through a slightly higher interest rate.
One other reason to avoid refinancing is that you are restarting your loan to refinance into another 30-year loan, which delays your final payment and costs more in total interest.
“Restarting your loan can be a concern depending on how far along you are in your loan payments,” Cunningham says. “You and your lender need to determine the total amount of interest you’re paying on your current loan compared to the interest you’ll pay on your new loan plus any cost of refinancing.”
To offset the additional interest, you can prepay your loan with extra payments to reduce your principal, or you can choose a shorter loan term. However, Cunningham says that if you have refinanced before and are not lowering your interest rate significantly, the payments on a shorter loan term could be much higher than your current payment.
“Shortening your loan term will save a lot of interest, but I don’t suggest doing that unless you’ve paid off all your other debt, are maxing out your 401(k) and have an emergency savings account,” Cunningham says.
If you haven’t applied for a mortgage in a few years, be prepared for more rigorous scrutiny of your finances than in the past. You’ll need to provide full documentation of everything, and your home must be appraised.
To qualify, you need to meet the following guidelines:
•Your loan-to-value must not exceed 95 percent for a conventional loan or 96.5 percent for an FHA-insured loan. If your loan-to-value on a conventional loan is more than 80 percent, you will need to pay PMI.
•Your debt-to-income ratio must be 43 to 45 percent or less (meaning the minimum monthly payment on all recurring debt must be 43 to 45 percent or less of your monthly gross income) for conventional financing. The ratio can be higher for an FHA loan, as long as you have a credit score above 700 or more home equity or cash reserves.
•Your credit score must be 740 or higher for you to be offered the lowest interest rates for a conventional loan. If your score is under 700, an FHA loan may be a better option. Most lenders require a credit score of 620 or 640 to qualify for a mortgage.
“Refinancing is worth a revisit if you were turned down in the past three or four years, because home values have risen,” Benner says.
Michele Lerner is a freelance writer.