There are many reasons you may choose to refinance your home. One reason is to get a better interest rate, which will lower your monthly payment. Even though interest rates are rising, the reality is that today’s rates are still at historic lows. They’re less than half of what they were in the 1980s and early ‘90s.
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You may also want to refinance to lengthen your loan term and lower your monthly payments. Or, conversely, if you can afford higher monthly payments, you could save yourself tens of thousands of dollars in interest payments by shortening your mortgage term. Another reason you may want to refinance is to convert an adjustable-rate mortgage into a fixed rate loan.
Whatever your reasons, the reality is that you do need to meet some requirements in order to refinance. We’ve laid them out for you below. Take a look to see if your finances are in the right shape.
Requirements for refinancing your home loan
When you apply to refinance the mortgage on your home, lenders look at three main factors to decide whether to approve you. These factors are:
- Your income: This is how much money you have coming in each month. Your income weighs heavily on your ability to pay back the new loan.
- Your home equity: Your home equity is the percentage of your home that you own outright. You can calculate this by subtracting the amount you owe on your mortgage from the value of your home. This will play a role in how much you’ll be allowed to borrow.
- Your credit score: Lenders use your credit score as a way to gauge how likely you are to pay back the loan. Conventional wisdom states that if you do well paying back other debts, you’re more likely to stay current with your next loan.
To determine whether you’re eligible to refinance, lenders look at a variety of financial indicators. We’ve listed the most common ones below to give you an idea of what to expect.
Debt-To-Income Ratio (DTI)
Your debt-to-income ratio is the sum of all your monthly debts divided by your gross monthly income. According to Jason Lerner, vice president and area development manager for George Mason Mortgage, LLC in Lutherville, M.D., this ratio can have the most significant impact on your eligibility. “The DTI tends to be weighed the heaviest because it shows your ability to repay the loan,” he said.
As for what counts as a financeable ratio, the Consumer Financial Protection Bureau (CFPB) says to aim for a ratio that’s less than or equal to 43%, though a ratio closer to 36% is more ideal. However, Lerner said that, in practice, exceptions are often made to that rule, especially if your other numbers are in line. “These days, it’s a good rule of thumb to shoot for a DTI of 50% or less.”
Financial thresholds for government-insured mortgages
That said, government-backed loans have different qualifying requirements. The Federal Housing Authority, for example, stipulates that for an FHA loan, your housing costs should not exceed 31% of your total income and your total DTI should not be larger than 43%.
Yet, even the Department of Housing and Urban Development (HUD) — the government agency that oversees the FHA — acknowledges that those requirements can be relaxed if there are other compensating factors involved. Those factors might be a down payment that’s larger than 10%, or substantial cash reserves.
With the FHA Streamline Refinance program, a program that lets you refinance an existing FHA loan into a new one, there’s no income verification. That means your DTI won’t even be a factor in the decision-making process.
On the other hand, the U.S. Department of Veterans Affairs (VA) as its own set of qualifying standards for refinancing. For a VA loan, the acceptable DTI is 41%. If you have an existing VA loan, however, you may be able to refinance your home with an Interest Rate Reduction Refinance Loan, which doesn’t have income requirements.
Equity is the percentage of your home that you own outright. The amount of equity you need to have in your home in order to refinance varies according to the lender and the loan program.
To find out how much equity you have in your home, you usually need to do an appraisal to get the current value of the home. But appraisals are not always done in the traditional sense anymore.
“The home’s value does need to be verified in some way, but it’s becoming more common to see appraisals done by computer,” Lerner said. Computer-generated appraisals use mathematical formulas to compare your house with information about the value of other homes in your area.
Even so, there are a few loan programs that don’t require an appraisal at all. They include:
- The VA Interest Rate Reduction Loan
- FHA Streamline Refinance Program
- HARP (Home Affordable Refinance Program)
Loan-To-Value Ratio (LTV)
Another way of expressing your home equity is by looking at your loan-to-value ratio, or the amount you owe on your home in relation to its overall value. For example, if you still owe $100,000 on a $300,000 home, your LTV would be 33% and your home equity would be 66%.
Not only is this ratio important in determining whether you’ll be approved for a loan, but it may also determine the interest rate you’ll get and other fees you’ll pay. In addition, many lenders require that homeowners take out private mortgage insurance if they have less than 20% equity in the home, or have an LTV that’s greater than 80%.
Will it be easier to qualify for the refinance if your LTV is below 80%?
Every lender has its own qualifying requirements, so it’s difficult to say what lenders prefer overall. But Lerner said having an LTV below 80% “isn’t a big concern” at his mortgage company, “especially if your other numbers, like your credit score, are in good shape.”
Lerner said in some instances, the amount you still owe on the home can be quite high. “Typically, it’s 80% to 85%,” Lerner said, “but if you’re just looking to reduce the payment or change the loan term, you can get closer to 97% or 100%.”
The main reason why a lender might want you to have at least 20% equity in your property is to minimize risk. Loans with high LTVs are thought to be one of the factors that contributed to the 2008 mortgage crisis.
In short, the less of a stake that a homeowner has in the property, the less likely they are to pay it off in times of crisis. When you have a high LTV, you have less skin in the game, which is riskier for the lender.
Credit score requirements
For the most part, lenders do look at your credit score when helping you to refinance your home. As far as what the credit score minimums will be, Lerner said they fall in line with the same qualifying requirements you’ll see for an initial purchase loan.
“For the most part, you’re going to need at least a 620 on a conventional loan and at least a 580 for an FHA,” he said. But for an FHA refinance, that number can drop down to 500, if you’ve got less than a 90% LTV.
However, there are ways to get around those numbers if you have certain government loans. “If you plan on staying with an existing FHA or VA loan, you may not have to run a credit check at all,” Lerner said. Again, the FHA Streamline Refinance Program and the VA Interest Rate Reduction Loan both offer limited underwriting requirements.
Can your credit score affect your refinance rate?
That said, there are advantages to making sure that your score is in the best shape possible before you go to refinance. Borrowers with lower scores are charged higher interest rates because they’re seen as a bigger risk by lenders. Building your credit score is one of the best ways to make sure your payment stays as low as possible.
The bottom line
Homeowners have to meet certain benchmarks to be able to refinance their mortgages. But if you don’t meet all of them all, don’t stress. There’s a lot of flexibility in the qualifying requirements and many different loan programs to choose from. Once you’re ready to start working with a lender, he or she can help you zero in on the program that will work the best for you.