New Rules of Refinancing Your Home

With the 30-year fixed mortgage rate flirting with 3%, a lot of homeowners should be able to cut their mortgage payments by hundreds of dollars a month. But despite an uptick in refinancings in 2012, the number is lower than in past booms, according to CoreLogic, a mortgage data firm.

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Inertia accounts for some of the reduced traffic to loan officers—after all, if you snagged a 5% rate three years ago, you’re probably still patting yourself on the back. But a lot of borrowers face serious obstacles to lowering their rate. Six years after the housing bust, mortgage lenders are still skittish about making loans. Even the biggest banks, now enjoying record profits, worry that if their loans default, the agencies that guarantee them—Fannie Mae, Freddie Mac and the Federal Housing Administration—will find errors in underwriting and force the lenders to buy back the loans and swallow any losses.

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Lenders also anticipate new mortgage rules, as yet unwritten, as required by the Dodd-Frank financial reform law. Hypercautious in the face of uncertainty, the lenders have overlaid the agencies’ stiff lending guidelines with even stiffer ones of their own.

Despite rising home prices in many cities, more than one-fifth of U.S. homeowners are still underwater on their mortgages—that is, they owe more on their loans than their homes are worth. They can't refinance unless they qualify for the Home Affordable Refinance Program (HARP) or FHA Streamline (see our story: How to Refinance Your Home If You're Underwater).

A Higher Bar

You'll need at least 5% to 10% equity in your home to get past the application process. (You can find a rough estimate of the market value of your home at Zillow.com. Even better, ask a real estate agent, who may get your business down the road, to provide a market valuation of your home based on recent comparable sales.) To make a refi worthwhile, you must keep your house long enough for the savings in monthly payments to cover the closing costs (closing costs average 2% of the loan amount, according to Bankrate.com). Beef up your credit profile if you can, and prepare to fork over heaps of documentation.

Sarah and Jim Roscoe of Grayslake, Ill., north of Chicago, recently traded in an FHA mortgage with a 30-year fixed rate of 6% for a 15-year loan with a rate of 3%. The new mortgage increases the couple's monthly payment by about $200, but by refinancing to a shorter term, they’ll save $155,754 in total interest. And with a plan to pay extra principal each month, they'll trim interest even more and meet their goal of retiring their mortgage before their daughters, now 6 and 4, head to college.

The Roscoes had impeccable credit and little debt other than their mortgage. They bought their home for $218,500 in 2009 with only 3.5% down. Despite falling home prices since then, their home was appraised at about $245,000 because they did extensive remodeling. Still, their mortgage balance divided by the value of their home, known as the loan-to-value ratio, was 88%, meaning they only had 12% equity. Homeowners must have at least 20% equity to avoid paying private mortgage insurance. Their lender, A&N Mortgage Services, in Chicago, offered the Roscoes the PMI coverage for half of the usual cost because they belong to a credit union, whose members are less likely to default than other borrowers. They rolled $1,000 of closing costs into the loan balance.

Check Your Credit

To meet standards set for refis by Fannie Mae and Freddie Mac, lenders expect you to have a FICO credit score of at least 660 to 680, a housing-debt-to-income ratio of no more than 28% and a total debt-to-income ratio of 36% or less. Your likelihood of nabbing the best rate and lowest closing costs goes up with a high credit score, an unblemished credit history, low debt and a high percentage of equity in your home. It also helps if the home is your primary residence, you take a shorter term (15 or 20 years) and you have sufficient financial reserves.

One thing that could disqualify you immediately is your mortgage payment history, says Ramez Fahmy, of Caliber Funding, in Bethesda, Md. For example, recent mortgage payments that were late by 30 days or more will give a lender pause. If you have a second mortgage or line of credit, that lender will have to agree to "resubordinate" its right to repayment behind the new first-mortgage lender if you default.

Mary Ellen Nicol, of CredAbility.org, a national consumer credit-counseling agency, advises that you double-check your credit reports from Equifax, Experian and TransUnion (free annually at annualcreditreport.com) to ensure that no errors drag down your score. At myfico.com, you can get a FICO score (the most commonly used credit score) and a credit report from Equifax or TransUnion for $20.

If your credit is less than stellar, it pays to check out smaller banks, credit unions and mortgage brokers who can help you find a loan program. Multiple credit checks won't diminish your credit score if they occur within a three-week period, but Nicol suggests that you add a buffer by completing the task in two weeks. (For more tips on improving your credit score, see our story: 6 Things to Know About Credit Scores.) Once the refinancing is under way, don't open new credit lines or increase the balances of your existing credit, because lenders will reverify your debt-to-income ratios just before closing. If the ratios exceed the lender's limit, it must requalify you.

Prove it—and Then Some

A good mortgage loan officer will let you know what documentation you need to provide upfront (typically pay stubs, W-2 forms, tax returns, and bank and investing statements). If you don’t help your loan officer meet the lender's deadlines, you may have to start over (in which case you’ll lose the rate you locked in). You can expect additional requests for documentation once your application goes to the underwriters, who scrutinize your application and documentation.

In most cases, Fannie, Freddie and the FHA demand that you have two consecutive years of income under your belt. Income that you use to qualify (such as salary, bonuses and commissions) should be expected to continue for at least three years.

Lenders typically demand that you explain any gap in employment of 60 days or more, says Fahmy. But you may pass muster if you’ve worked for your current employer for at least six months and have a steady employment history prior to your hiatus. Lenders may also approve you if you took maternity, medical or family leave and returned to the same employer.

If you have less than a two-year work history but you were attending school or a retraining program before you began your job, you may still qualify. If you're self-employed, the agencies look for at least two years of self-employment income on your tax returns. But lenders could require more, says Fahmy.

Withdrawals from savings don’t count as income. But if you are retired and have been tapping a 401(k) or IRA for three months or more, that does count as long as you have enough funds to cover three years of income at that withdrawal rate, says Fred Arnold, director and treasurer of the National Association of Mortgage Brokers.

Finally, you must show lenders that you have funds to cover closing costs—or income high enough to cover a bigger payment, if you roll them into the loan—as well as enough savings to cover at least two months of mortgage payments (and sometimes six months or more). Reserves must typically have been in a savings or investment account for at least two months. Lenders will count just 70% of the money in your retirement accounts.

Home Valuation Hurdles

If your home is appraised for less than you expect, you have a couple of options. One is to bring more cash to closing to reduce the loan balance to 80% of the value of your home—if you have enough to cover closing costs and necessary reserves, too. Or, if your loan-to-value ratio is higher than 80%, you can pay for private mortgage insurance, which protects the lender if you stop making payments. Because home values have fallen, many homeowners who didn’t need PMI when they bought will need it when they refinance. "People are phobic over mortgage insurance because somebody years ago told them it was evil," says Betsy Lewin, the Roscoes' Chicago mortgage broker. But you have to balance its cost with its benefit.

PMI costs from about 0.5% to 1.5% of your loan amount per year, according to the Mortgage Insurance Companies of America. You can cancel PMI when your loan-to-value ratio falls to 80%. (At 78%, the lender must cancel it automatically.) You'll reach that point more quickly if you refinance into a shorter-term loan or make additional loan payments.

With "lender-paid mortgage insurance," you can fold the cost of PMI into the interest rate you pay. The less equity you have, the higher the adjustment to your rate. For example, if a borrower with 20% equity qualifies for a 30-year fixed rate of 4%, a borrower with just 5% equity might have to pay 4.375%. The higher rate applies for as long as you have the loan, so this option makes sense only if you don't plan to own your home for the long term. But if you itemize on your tax return, you can deduct all of the mortgage interest.

You could refinance into an FHA loan, which requires just 3.5% equity. However, with recent increases in FHA's upfront mortgage insurance and monthly premiums, PMI could be cheaper. Ask your loan officer to help you run the numbers to see what works best for you.

This article first appeared in Kiplinger's Personal Finance magazine. For more help with your personal finances and investments, please subscribe to the magazine. It might be the best investment you ever make.