As the federal reserve cuts interest rates, refinancing your mortgage might be less expensive. However, you may find it harder to refinance now, as lenders crack down. The key, more than ever, is to boost your credit score.
When Jay and Quiana Williams bought their Chicago home in the spring of 2006, some credit issues made mortgage shopping difficult. Quiana’s credit was just OK. “When we applied for a mortgage, we only used Jay’s credit score,” says Quiana, 33, a software engineer. Jay’s score was considered good (mid 600s) and Quiana’s was fair (low 600s). Jay was allowed to qualify for the loan by himself, but combine Quiana’s income when applying. This arrangement was one reason they would end up paying higher interest rates.
A mortgage broker put together a package of two loans for the $536,000 they needed to borrow. Rates were steep, though; a 15-year balloon mortgage (relatively reasonable monthly payments but a large amount due at maturity) for $84,000 had a rate of 12.25%, and a seven-year adjustable rate mortgage for $452,000 had a 7.2% rate.
Fast-forward 16 months to July 2007. “Jay and Quiana are poster children for doing everything right to bring down their mortgage costs,” says Chris Long, a Chicago-based financial planner who advises the couple. “They made sure they paid all their bills on time and they checked their credit scores regularly.”
Quiana’s credit score had improved so much that the couple could use both scores to refinance their high-rate loans last year. By then, when old late payments rolled off their credit reports, Quiana’s score had increased by about 50 points and Jay’s by about 20. Generally, late payments are reported for seven years. Jay says that their continued track record of on-time payments raised their scores even further by early 2008: Jay was at 795 and Quiana at 705.
“Our mortgage broker got us a 30-year fixed-rate loan at a little more than 7% and a 15-year balloon, at under 9%,” says Jay, 33, the CFO of a food service distribution company. “We reduced our mortgage payments by about $550 a month.”
Know the score. The Williams’ experience can serve as a lesson for any homeowners carrying high-rate mortgages. “Today, superior credit scores are vital for anyone who wants to refinance,” says financial planner Long. “To get the best rates, you would need a score of 720-plus for most lenders. You might be able to refinance if your credit score is between 620 and 680, but you might pay a high interest rate.” Scores range from 300 to 850.
Long suggests that anyone thinking about refinancing find out their credit score before making an application. “You can get a score for a modest price, $15.95, at myFICO.com,” Long says. “For a married couple, both spouses should get their scores. Once you know your credit score, you’ll have a better idea of the terms you can expect from a lender.”
Equity expectation. Having a good credit score may only be the beginning, now that lenders are taking a hard look at applicants. “You’ll need at least 10% equity in your home now, to refinance,” says Keith Gumbinger, vice president of HSH Associates, a publisher of loan information based in Pompton Plains, New Jersey. That is, don’t expect to borrow more than 90% of your home’s appraised value.
For
example, if a lender thinks your house is worth $200,000, you probably can borrow no more than $180,000. If you don’t have any home equity, you might be able to refinance, in this example, by putting in $20,000 of your own money, but who wants to put thousands of dollars into housing now, just to refinance a loan?You also can forget about no-documentation loans, which were available a few years ago. “You’ll have to show proof of income, perhaps from a tax return,” says Gumbinger. “You also may have to present financial statements that show your overall debt load is manageable, compared with your income.” Typically, lenders want to see that all of your monthly payments (house, cars, and credit cards) don’t exceed 45% of your pretax income.
Rewards of refinancing. Assuming that you have it all — an excellent credit score, ample equity in your home, substantial income — does it make sense to refinance now? Yes, in some situations:
If you have an ARM, refinancing to a fixed-rate loan may be a good move. Many ARM rates will reset this year. For people who have ARMs, the good news is that short-term rates are low. ARM reset rates generally are pegged to short-term interest rates, such as the yields on one-year Treasuries. If your ARM has a benchmark that has come down with the Fed cuts, your reset will be much lower than it would have been a few months ago — perhaps even under 5%.
With fixed-rate, 30-year mortgages now averaging close to 6%, refinancing an existing ARM to a new fixed-rate loan might raise your monthly payments.
“However, refinancing to a fixed-rate mortgage
may make sense if you’re nervous about future ARM resets and you’re not planning to move,” says Long. “A fixed mortgage payment takes some of the uncertainty out of your financial planning, and mortgage rates are low now, by historic standards.”If you think you might move, refinancing an existing ARM that will reset every year to a new ARM may pay off. “You might be able to lock in a rate under 6% for the next five years,” says Gumbinger.
If you have a fixed-rate mortgage, you might be able to get a better rate now. In this situation, deciding whether to refinance is a numbers game. First, see how much you’ll save by refinancing. You can shop online for lenders charging below-average interest rates. Then, get a good-faith estimate of the total costs you’ll incur from the lender or mortgage broker, as required by law. Finally, see whether you expect to be in the house long enough for the future savings to offset the up-front expense.
For example, say it costs you $4,000 in fees to refinance a $200,000 loan. (Total refinancing costs usually are 2% to 3% of the loan balance, according to Gumbinger.) Suppose you’ll cut your payments by $1,600 annually. In three years, you’ll have saved $4,800: $1,600 times three. So this refinancing makes sense if you plan to stay in your house for three years or longer. “Typically, refinancing will be a good move if you lower your interest rate by at least a full percentage point and you plan to stay in the house for a few years,” says Gumbinger.
If you have a jumbo mortgage, a new federal law may offer a cost-cutting opportunity. If your home loan is for more than $417,000, you may have what is known as a jumbo loan. Rates on jumbo loans are much higher than rates on smaller loans, known as “conforming” loans, because borrowers meet guidelines from Fannie Mae and Freddie Mac. The reasons for this spread are complicated, but the bottom line is that investors who buy mortgages have stronger guarantees with conforming loans so they’re willing to accept lower yields.
As a result, borrowers pay lower rates for conforming loans. While 30-year conforming mortgages now average close to 6%, 30-year jumbo loans average about 7%. Under a new law, though, the ceiling on conforming loans has been raised in certain areas, through the end of 2008. Mainly in parts of the Northeast and California, the Federal Housing Administration can insure much larger loans. Fannie Mae and Freddie Mac will be allowed to purchase those larger loans, delivering an implicit federal guarantee to investors.
In Los Angeles and San Francisco counties, for example, mortgages up to a maximum of $729,250 will be considered conforming loans, eligible for federal guarantees. Those guarantees may knock down the costs of some new loans larger than $417,000, making refinancing a jumbo cost-cutter.
10 REFINANCING MISTAKES TO AVOID
- Ignoring a possible prepayment penalty Not doing a break-even analysis
- Not choosing the correct loan — fixed-rate, ARM, etc.
- Signing documents without reading them completely
- Failing to shop around for a lender
- Borrowing too much
- Refinancing too often
- Not getting a written estimate of closing costs
- Acting under pressure; be willing to walk away from surprises
- Failing to lock in an interest rate
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