9 things to do before you refinance your mortgage

The Mortgage Bankers Association reports that refinances comprised a significant portion of mortgage applications during the last half of 2019. The relatively low interest rates during this period were encouraging homeowners to refinance existing mortgages that were originated when interest rates were higher. However, the issue of whether you should refinance often depends more on your personal circumstances than on current market conditions. The following nine tips will show how you can maximize your chances of getting approved for a mortgage refinance.

1. Learn about mortgage interest deductions

Homeowners may be able to deduct a portion of their mortgage interest on their federal tax returns, resulting in a lower tax bill. This is especially true at the beginning of the loan term, when the majority of your mortgage payment is interest. However, tax deduction of itself is rarely an adequate reason for refinancing your mortgage.

Furthermore, the Tax Cuts and Jobs Act passed in December 2017 makes it less likely that itemizing your deductions will provide you with a tax advantage. The new standard deduction is now $24K for married couples filing jointly, compared with $12.7K prior to 2017, meaning that many will see no advantage in itemizing. However, homeowners with more than $750K in mortgage debt will benefit under the new law provided they purchased their home on or after December 15, 2017. The maximum deduction for mortgage interest is now $1M, as opposed to $750K under the previous tax law.

2. Know your home equity

Home equity is the amount of your home’s value that you own. It is a critical factor when refinancing your home. You can calculate equity by subtracting your mortgage balance from your home's fair market value. Assume for this example that your house is worth $400K and your mortgage balance is $260K. Your equity would therefore be $140K. Equity is often expressed as a percentage of your home's value, which would be 35% in this example ($140K/$400K) x100). Lenders generally prefer borrowers to have at least 20% equity, although they will often approve loans with less equity. However, you can expect the cost of your refinance to be significantly higher if your equity is below 20%.

3. Ask about private mortgage insurance

Lenders typically require you to get private mortgage insurance (PMI) if your equity is below 20%. This type of insurance allows the lender to recoup in the event you default on your payments. The need to pay PMI on a refinance may not make that big of a difference to you if you're already paying it on your current mortgage. However, homeowners with a low amount of equity may need to pay PMI for the first time if their home has decreased in value since they took out the original mortgage.

4. Calculate your debt-to-income ratio

Your total debt payments divided by your total income equals your debt-to-income ratio. Lenders have become considerably stricter about their debt-to-income requirements over the past decade, largely as a result of the subprime mortgage crisis in the United States that ended in 2009. Your total debt-to-income ratio ideally should be no more than 36%, although you may be able to refinance if it's as high as 43% provided your other risk factors are sufficiently positive. Furthermore, your mortgage payment should be no more than 28% of your gross monthly income, regardless of your total debt-to-income ratio.

5. Compare rates and terms

Borrowers often focus on the interest rate, which is a highly important reason for refinancing your mortgage. However, you shouldn't neglect the other loan terms, especially the duration of the loan, when making your decision. While a low interest rate with a long payback period will minimize your monthly payments, the total cost of your refinance will be less if the loan has the shortest term that still allows you to make your monthly payments consistently.

6. Consider refinancing points

Points are another factor to consider when comparing mortgage refinance offers. When you pay points, you are trading off more upfront expense for a lower interest rate on your refinance. Each point is the equivalent of 1% of the value of your current mortgage. You can either pay points on your loan at closing or include them in the principal of your new loan. Lenders have tightened their standards for approving refinances with points in recent years.

7. Reduce refinancing costs

The costs of refinancing your mortgage are usually 3-5% of the loan amount, although there are ways to avoid paying them out-of-pocket. If you have enough equity in your home, you can often wrap these costs into the new loan, which will increase your principal. Some lenders offer "no-cost" home refinancing, which usually means they increase the interest rate so that the additional interest income will cover the closing costs. Be sure to take refinancing costs into account when comparing offers.

8. Calculate your break-even point

A refinance might make sense if you expect to keep your house long enough for the savings to exceed the closing costs. The time needed to recoup the cost of refinancing your mortgage is commonly known as your break-even point. You can calculate your break-even point by dividing your closing costs by your monthly savings. Assume for this example that the closing costs for your refinance are $3K, but that you will save $100 per month with a lower payment. You would need 30 months, or 2.5 years (3,000/100), to break even.

9. Consider whether you need cash

A cash-out refinance is one in which the principal of the new mortgage is greater than that of the one it is replacing, allowing the borrower to receive the difference in cash. This type of refinance is typically used to pay for major home repairs, especially those that increase a home's resale value. A homeowner who already has a low rate, or doesn't want to refinance could consider a Figure Home Equity Line to tap their home equity without affecting their existing mortgage.