Reader question: “I will be attempting to refinance my home loan in spring 2014. I say ‘attempting’ because I don’t know if my credit is good enough. I need to get a good interest rate on the new loan, so I can lower my monthly payments as much as possible. That is my number one goal. How can I get the best interest rate when refinancing my mortgage? Is it all based on credit scores, or is there more to it than that?”
You’re right. Getting the lowest possible rate on your new loan is important. It helps you lower your monthly payments and save money over time. So let’s talk about how you might accomplish that.
If you want to get the best interest rate when refinancing, you will probably need the three factors listed below.
1. At Least 20% Equity in Your Home
With most lenders, this is something you’ll need just to qualify for a refi. Your credit score matters. But your current equity level matters even more. It is arguably the single most important factor when refinancing. It also influences the rate you receive from the lender.
If you want to get the best mortgage rates on the new loan, you’ll probably need to have positive equity of at least 20%. In other words, your current mortgage balance should not account for more than 80% of the appraised home value. You should have at least 20% ownership of the property. This is not a hard and fast rule or anything — it varies from one lender to the next. It’s just a rule of thumb. To qualify for the lender’s lowest rate when refinancing, you need a significant amount of equity. And that probably means 20% or more.
Just to be clear, we are talking about getting the best rate here. You don’t necessarily need 20% equity just to be approved for a refi.
To figure out how much equity you have, you’ll first need to determine the current value of your home. This is a simple calculation. You simply compare your outstanding loan balance to the current appraised value of your home. Then you’ll know where you stand in terms of equity.
The math looks like this…
Current market value of home – Outstanding mortgage balance = Your home equity
Example: If my home is worth $200,000, and I have $120,000 left to repay on my mortgage, my equity would equal $80,000. To convert this into a percentage, I would simply divide the 80k by the 200k home value (80 ÷ 200 = 0.4 or 40%). So I have 40% equity in my home.
2. An Excellent Credit Score
Good credit has always been a requirement for getting the best mortgage rates when refinancing, and it’s still true today. The only difference is that you’ll need an even higher score to qualify for the best rates in 2014, compared to a few years ago. How high does it need to be? This will vary from one lender to the next, but you’ll probably need a FICO score of 760 or above to qualify for those top-tier interest rates.
(Again, this is not the score you would need just to qualify for a refinance loan. We are talking about getting the best rates.)
The first step here, obviously, is to find out where you stand. You should obtain all three of your scores from Equifax, TransUnion and Experian. Don’t wait for a lender to tell you what your score is. Find out for yourself, and find out today. You need excellent credit (generally defined as being somewhere between 750 and 850) to get the best refinancing rates, so you need to obtain this information as soon as possible.
If you find out that your score is low, you can improve it by reducing your outstanding debt and paying all of your bills on time. These are the two most important steps to take when improving a credit score, and when combined they will help you achieve success faster than anything else.
3. A Favorable Debt-to-Income Ratio
When you apply for refinancing, the lender will also evaluate your current debt level in relation to your income. Debt-to-income ratio, or DTI, is simply a comparison between your gross monthly income and the amount you pay toward your various debts each month. So if John and Jane gross $7,000 each month (combined), and they pay $1,500 on all of their debts, their household debt-to-income ratio is about 21%. In other words, 21% of their gross monthly income goes toward their debt.
In fact, John and Jane are a pretty good model for where you should be with your DTI ratio, if you want to get the best mortgage rate when refinancing. I would recommend 20% or lower. You might be able to get qualified with a DTI higher than that, but you probably won’t get the best rates — and that’s what this Q&A session is all about.