Refinancing can be smart for mortgages above 5 percent

Although many homeowners have refinanced during the last five years of historically low mortgage rates, you’re not alone if you don’t have your own rock-bottom rate. Maybe your credit score prevented you from getting a top rate at the time, or perhaps you opted for an adjustable-rate mortgage that has since seen its rate rise. Or maybe refinancing seemed so daunting you just never got around to it.

 Whatever the reason, if your APY is above 5 percent, you’re a good candidate to investigate refinancing. That threshold comes from two factors: a national average for 30-year fixed mortgages that’s currently hovering around 4 percent, and the rule of thumb that refinancing is often worth it when you can lower your rate by 1 percent or more.

 Drop your rate from 5 percent to 4 percent on a $150,000 mortgage balance and you’ll save about $90 a month. But beyond the lower payment, you’ll also be putting more towards principal every month because you’ll be spending less on interest. That means you’ll build equity in your home more quickly.

 Of course, some research and shopping around will be required. As the name implies, the national average is a middle number of all the mortgage rates currently on offer across the country. So while some lenders are charging more, you can find others charging less.

 Obviously, the lower the rate you can lock in, the better, assuming the associated costs are reasonable. Fees vary widely, so shopping for your best option means comparing not just the rate for each mortgage, but also that lender’s estimated refinancing costs.

 While some refinancing options carry a hefty expense that won’t make economic sense for you, others will be affordable enough that you can easily recoup the expense with savings from your new, lower interest rate.

Pre-Qualification vs. Pre-Approval

If you’re shopping for a new home, it’s smart to get a mortgage lender involved early. But does that mean getting pre-qualified or pre-approved? Knowing the difference can save you from a common homebuyer mistake and possible missed opportunities.

 Pre-qualification is easier and comes first for most buyers. Based on debt, income and asset information you provide, the lender recommends the type and amount of mortgage they’ll likely approve for you. The process is quick and generally free, and involves no credit analysis.

 As a result, the pre-qualification amount is only an estimate of what you might be able to expect. If you’ve overlooked reporting any debts, have overstated income or assets, or have less than excellent credit, you may find out later your approved mortgage amount is less than your pre-qualification.

 Once you’ve gotten serious in your house hunting, it’s wise to apply for pre-approval and pay the fee it usually requires. Here, you provide information for the lender to confirm and analyze your debt, income and assets, as well as your credit score and report.

 With this, the lender can commit on the type and amount of mortgage they’re willing to offer you, as well as the rate. This is conveyed in a conditional commitment letter, which confirms you have financing for homes at or below the approved amount.

 If you’re sure you plan to buy, pre-approval offers advantages that are worth the application fee. Not only does it help you avoid wasting time on homes beyond your price range – it can also give you an edge with a seller, as it demonstrates you can move quickly without a contingency to secure financing.

 Pre-qualification is a great first step for most home buyers, but as soon as the house hunt becomes serious, pre-approval becomes your next smart move.

Home equity loan vs. HELOC

If your home’s value sits well above your mortgage balance, tapping into that equity for home improvements or consolidating debt can be a smart financial move. Both home equity loans and lines of credit allow you to do that, so which should you choose?

 Both access the value in your home that belongs to you, but that you otherwise wouldn’t reap until selling the property. Both also offer lower interest rates than credit cards and personal loans since they’re backed by your home’s collateral, with the added bonus of the interest being tax-deductible.

 The difference lies in how you’ll access the money. A home equity loan is like most other loans you’d request from a bank, where you apply for an amount and, if approved, the bank extends a lump sum at a fixed interest rate.

 Home equity lines of credit, or HELOCs, work more like a credit card. The bank sets a limit based on your equity and lets you draw from the HELOC as needed, usually at an adjustable rate. Banks generally offer HELOC access via checks and bank transfers, with some also providing a debit card.

 How you’ll use the funds will determine the better fit for you. Consolidating higher-interest debt? Then a home equity loan will work well, giving you a lump sum to pay off those balances and convert them to a single, more affordable payment going forward.

 But if you’re tapping funds for home improvement, paying contractors throughout the project, a HELOC lets you borrow the money in flexible amounts at different times. A HELOC can also be useful as an emergency cushion, sitting untapped unless you need it.

 With their low interest rates and tax advantages, home equity loans and HELOCs are among the most valuable financial tools available to homeowners with built-up equity.

What is the loan-to-value ratio?

For lenders, extending mortgages is a risk calculus. The riskier it seems that a homebuyer will repay their mortgage in a timely manner, the higher the rate the bank will offer. Meanwhile, for applicants appearing to be safer bets, banks extend more attractive terms.

 One of the top-level measures lenders use to determine the risk factor of any applicant is the loan-to-value ratio. This calculation determines what share of the home’s value will be mortgaged, by dividing the requested loan amount by the home’s appraised value.

 Take the example of a home appraised at $250,000. If you make a $25,000 down payment, the requested mortgage will be $225,000. Divide that by the $250,000 appraised value and you get a loan-to-value ratio, or LTV, of 90%. If instead you put down $50,000, the mortgage drops to $200,000 and with it, the LTV to 80%.

 Lower LTV ratios will garner better rates, within certain tiers. For instance, 80% is the standard threshold at which almost all lenders will offer a lower APY. That’s not to say you can’t get a mortgage with a 90% or higher loan-to-value. FHA loans, for instance, are generally only provided for LTVs of at least 90%.

 But while 80% is a worthy goal for any homebuyer aiming to get their best deal, dropping the ratio even lower can earn you still better rates. Most lenders will lower their rates at every 5% or 10% LTV mark, so putting enough money down to achieve a 75% or 70% loan-to-value ratio will reward you with a lower APY. There is a limit, though, with lenders typically stopping the rate drops after reaching a 60% LTV.

 Once you know the home’s appraised value, understanding loan-to-value ratios enables you to target your down payment to secure the best mortgage rate available.

How high a credit score do I need to get a good mortgage?

Whether you’re applying for a new mortgage or just refinancing, your three-digit credit score will factor heavily into how attractive a rate you can get, or if you’ll be approved at all. While those with the highest scores enjoy the lowest rates, mortgage lenders classify applicants into four tiers of scores to determine their offer.

 The credit rating lenders rely on is your FICO score, which ranges from 300 to 850 based mostly on how often your payments have been on time, how much you owe, and how long your credit history is.

 Generally, the lowest score that can secure a mortgage is 620. One big exception is the government’s FHA program, which helps those with subprime credit. While an FHA loan can be secured with a score as low as 500, or 580 for the low-down-payment option, most applicants with scores this low are denied.

 Once you surpass 620, you’ll have more options – and a chance at better rates – from conventional bank lenders. Boost your score higher to 660 and the number of lenders willing to take your application will increase again, with rates coming down further.

 The next threshold is a score of 700 or better. Applicants with these “very good” scores have exceptional odds of approval, and the rates offered will be close to the best available.

 So what then is the brass ring that earns the very best rates? That threshold generally sits around 750. Some lenders set the bar at 760, while others have published a 740 minimum, so it’s worth asking any lenders you approach what threshold they’ve set.

 Knowing your score before applying for a mortgage can be a money saver if you find you’re close to the next tier. A few smart credit moves might be all it takes to earn yourself to a better rate.