If you’re already a homeowner, you’ve probably seen your equity increase dramatically this past year. According to data reported by CoreLogic, between the third quarter of 2019 and the third quarter of 2020, U.S. homeowners with mortgages saw their equity increase by a total of one trillion dollars, an increase of 10.8 percent. Simultaneously, interest rates have been historically low, with some lenders offering less than 3 percent for their mortgage. Given those factors, you’ve probably thought that this might be a good time to consider refinancing. There are a few things to know first.
Know Your Credit Score
While historically low interest rates have been driving people to look into refinancing, not everyone will be offered a rate of 3 percent or lower, even if they have good credit. To lock in the absolute lowest interest rate available, many lenders are requiring a credit score of 760 or higher. If your score is lower, you still could receive a more favorable interest rate than the one you’re currently locked into, but it’s best to manage your expectations.
Know Your Debt-to-Income Ratio
In addition to higher credit score requirements, lenders are scrutinizing people’s debt-to-income ratio a lot more intently. In order to get the best rates, lenders usually want to see that your housing payments are 28 percent or less of your gross monthly income. Overall, your debt-to-income should be 36 percent or less, although with some additional positive factors – such as a higher income, substantial savings, or ownership of other assets – some lenders will go up to 43 percent. If possible, it’s in your best interest to pay down your debt before seeking refinancing.
Be Prepared for Refinancing Costs
Typically, refinancing costs about 2 to 5 percent of the principal amount of your loan. Make sure that this added expense won’t cancel out the benefits of your refinancing. Some lenders offer a “no-cost” refinance, but that typically means that you will pay a slightly higher interest rate to cover the closing.
Be careful that your refinancing costs don’t cancel out whatever advantage a lower repayment would offer. To determine if the refinancing makes financial sense, divide your closing costs by the amount you would save every month. Once you know how many months it would take to pay off the refinancing expenses, you’ll know whether you’d benefit from refinancing. For example, if you were to save $100 per month on your payments, and the closing costs are $4,000, it would take you 40 months to break even. If you plan to live in your house for longer than that, then it makes sense to refinance.
Your Mortgage Interest Tax Deduction May Change
If you decide to refinance, your mortgage interest deduction could decrease— unless it increases. This will vary from borrower to borrower depending on their actual situation, but if your monthly repayment decreases and you’re paying a lower interest rate, the amount you can deduct for your mortgage interest will also be lower. However, some mortgages are structured so that the interest is repaid before the principal, in which case you could have a larger deduction in the first year or couple of years.
