The average rate on 30-year fixed mortgages hit a three-year low of 3.73% at the end of June, which means that for millions of homeowners, refinancing could lead to big savings.
"The average borrower could save about $266 per month, bringing the total amount of potential savings to about $2.2 trillion," CNBC'S Diana Olick reported.
But if you're considering refinancing, it's important to know what you're signing up for. "You really need to be an informed borrower," John Cooper, a certified financial planner at Greenwood Capital, tells CNBC Make It.
Here are six steps to follow to successfully refinance your home.
Although many homeowners could save money by refinancing, it isn't the right choice for everyone. Start by asking yourself the following three key questions to determine if it's worthwhile for you.
Will you earn your investment back?
It's crucial to remember that refinancing isn't free. In order to secure a lower interest rate, you'll end up paying closing costs again, which can include bank fees, appraisal fees and attorney fees, among other things.
These costs typically run between 1% and 2% of your total mortgage balance, although that can vary, Cooper tells Make It. On a $300,000 mortgage, for example, you would expect to pay around $6,000 in fees.
Before refinancing, you should calculate how long it would take you to earn that money back. "It's best to recoup the closing costs in five years or less," Cooper says. "You don't want to extend it too long, or else you're not really making a lot of headway."
You should also consider if you plan to sell your home in the near future. "If you won't be in the house long enough to recoup the cost and time, it is not worth it," Kristin Baker, chief of staff at White Oaks Wealth Advisors, tells CNBC Make It. "Have your lender run a break-even analysis so you know exactly when the savings outweigh the costs and make sure you plan to be in the home that long."
How seasoned is your loan?
Consider how long you'll be paying down the rest of the mortgage so you don't lose your potential savings to additional interest costs. "If you are five years into a 30-year mortgage and you refinance into another 30-year mortgage, you are going back to the beginning and may pay more in total interest," Baker says.
However, that doesn't necessarily mean that you should refinance into a shorter term mortgage. "If a borrower isn't too far into the loan term they may still end up paying less in interest if the rate is reduced enough," Baker says. "Furthermore, most people don't stay in their homes for a full 30 years; often the full effect of the interest over the whole term isn't realized."
Scott Frank, a certified financial planner and founder of Stone Steps Financial, agrees that you shouldn't automatically jump into a shorter term mortgage. They often come with higher monthly payments, and "most people are looking to refinance because it will reduce their monthly payment which will allow them to put those funds to work in another area of their life," Frank tells CNBC Make It.
"If someone wants to pay off a loan faster, I prefer they get a 30 year fixed rate loan and pay it as though it is a 15 year loan," Frank adds. On a deeply seasoned loan, refinancing might mean that you owe a significant amount in interest. But if you're saving enough each month that you can increase your monthly payments to pay down the loan faster, you might be able to avoid the additional interest, he explains.
What are your other financial goals?
"When you are considering a change to your monthly bills, it's a good time to take a moment and consider your progress on other goals, such as saving for education, retirement or a wedding," Sean M. Pearson, a certified financial planner at Ameriprise Financial, tells CNBC Make It.
While refinancing could be a way to save money in the long-term, it's not worth it if the upfront costs put you in a financial hole. "Ask yourself if you have three to six months' worth of savings in the bank to cover things like a job loss, unexpected home repair or next year's vacation before you consider paying additional fees today," he adds.
Your credit score will help determine how favorable of an interest rate you'll be able to lock down. The higher your score, the lower the rate. In the first quarter of 2019, 90% of mortgages were taken out by home buyers with a score of at least 650, and 75% had a score higher than 700, the Federal Reserve reports.
When refinancing, how much equity you have in the home also matters. If you own less than 25% of your home, you'll likely need a higher credit score to be approved for a loan, Cooper says.
You also want to be aware of your debt-to-income ratio, which is a measure of how much you owe in debt payments each month versus your gross monthly income, Cooper says. If you bring in $1,000 per month and put $300 toward a mortgage, auto loan or other debt payment, for example, your debt-to-income ratio would be 30%. This calculation only accounts for the minimum payments you owe, not any extra cash you may be funneling towards debt.
Lenders generally look for a debt-to-income ratio of around 43% or less, Cooper says. If your refinanced mortgage comes with higher monthly payments it could push your ratio over the edge.
"You may be able to theoretically afford it, but the bank will see that your debt-to-income ratio is going up and they won't want to approve it," he says.
Once you've decided that refinancing is a smart move and that you're likely to score a good rate, start talking to mortgage loan officers and don't settle for the first decent offer. "I always recommend you shop around like you would if you were shopping for a new car or dishwasher," Cooper says.
Make sure each lender quotes you the APR, or annual percentage rate, for the mortgage, he adds. This number includes both the interest rate and any additional fees, so it's the best way to compare the total amount you'd owe to each lender.
And while you want the lowest rates, keep in mind that it's not solely about the money. "Customer service and the lender's reputation are also factors to consider," Pearson says.
You also shouldn't be afraid to play lenders against each other in order to negotiate the lowest rate, Frank says. "Go back and forth with lenders to get the best deal," he says. "You don't have to say yes to the first offers."
Once you've chosen a lender, gather all the documents you'll need to put in an application. This typically includes tax returns, pay stubs, W-2s, bank statements and proof of homeowner's insurance.
Lenders will sometimes ask for investment account statements as well, Cooper says, to double check that you're financially stable: "Do you have an alternative source of money if you get behind on your payments?"
Being organized upfront will help streamline the process and potentially cut down the amount of time it takes in the end.
Once you've done your homework, the actual act of refinancing is simple. Typically, you'll meet with your lender, lock in your rate and fill out an application. Next, you'll submit all of your documentation. From there, most of the work will happen behind the scenes by an underwriter who will assess your information.
"Typically, the borrower does not have to do much in this process other than provide additional documentation as requested and access to the property, if required," Baker says.
The process may take as little as two weeks or as long as three months, so be prepared to wait.
Once all of the underwriting is completed, you'll officially sign the documents. And if you've changed your mind, there's usually some wiggle room. "For most refinances, there is a three-day rescission period following signing in which you can decide not to go through with the refinance and have the documentation voided," Baker says.
Don't let the money you're saving by refinancing go toward lifestyle inflation. "I often tell my clients that it's easier to save money for another goal when you're not used to pocketing the extra cash," Pearson says.
Create a plan for your extra money right away so that you're able to make the most of it. "Even a modest amount can add up — especially if it's money you don't need for a while, like retirement," Pearson says.
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