Mortgage Refinancing Basics

by Miranda Marquit, Contributor

When interest rates start to decline, many homeowners contemplate mortgage refinancing. The basic rule-of-thumb is that you should refinance your mortgage when the interest rate offered is at least 1% lower than your current mortgage rate.

When you refinance a loan, you are essentially paying off your old mortgage and getting a new one. That means you will have to go through the steps of mortgage application and approval all over again.

READ: Cash-Out Refinancing vs. Streamlined Refinance

Here are some important things that you should know about mortgage refinancing:

Refinancing comes with fees
Since your refinance is basically a new mortgage, you will have to pay closing costs and other loan processing fees. Be prepared.

Your credit score still matters
Just like your first mortgage, your mortgage refinancing application will require a credit check. Be aware that if your credit score has dropped since your original mortgage loan was approved, you might not actually qualify to refinance for a better interest rate.

Your debt vs. income will be measured
Even if you can afford your current mortgage payments, the lender will look at your current income and debt obligations. A drop in your income could affect your attempt at mortgage refinancing.

Home equity is crucial
Gone are the days when you could obtain mortgage refinancing with little home equity. Mortgage lenders today want to see that you have some equity built up before they will approve your refinance. If your home has declined in value, or if your original mortgage is an interest-only loan for which you have not been paying down the principal, you may have difficulty refinancing. You might also be required to pay for an appraisal so that your home’s value can be determined.

Remember that mortgage refinancing, for the most part, replaces the amount of the loan you have left ― not the original purchase price of your home. Some lenders offer cash-out refinancing, which allows you to borrow more than you owe on your home and keep the difference (between what you borrowed and what is left on the original mortgage). However, you may not get as favorable terms with a cash-out refinance.

When engaging in mortgage refinancing, you should consider reducing the term of the loan as well. Instead of refinancing for 30 years and extending your loan out further, you might consider refinancing for 15 or 20 years instead. The monthly payments may be a little higher, but if you can afford slightly higher payments you will pay less interest over the long run ― and build equity faster.

Mortgage loan refinancing can be a great money-saving move, but only if you do it properly.