How Refinancing A Loan Works

Need to know how refinancing a loan works? You read the papers every day. You hear about it on the radio while you're driving to work. Mortgage interest rates have fallen to near-historic lows. You're ready to refinance your mortgage loan to take advantage of these low rates. You're looking forward to the lower monthly mortgage payment that comes with them. The only problem? You're not quite sure how refinancing a loan works.

Fortunately, the refinancing process, though a bit time-consuming, is actually fairly formulaic. The vast majority of mortgage lenders require the same documents from their borrowers. Most of them even look at the same financial factors when deciding to whom to loan money. There's no excuse, then, to let your lack of knowledge about refinancing a loan prevent you from taking advantage of today's low mortgage interest rates.

When refinancing a loan, it's important to shop around. Different lenders will charge different fees and interest rates. Remember, you are not required to work with the lender that is already servicing your loan. Once you find a lender that you like, you'll have to send the company copies of your last two years worth of tax returns, your two most recent paychecks, bank saving and checking account statements, your most recent credit card bills and any other loan statements—such as student or auto—that you might have. Your lender will look at these to make sure that your monthly debt obligations, including the estimated value of your new mortgage payments, is less than 36 percent of your gross monthly income.

Next, your lender will review your credit. This will give them your three-digit credit score. Scores of 740 or higher will qualify you for the lowest interest rates. Scores under 620 might mean that you'll have to take out a subprime loan, a loan that comes with higher interest rates.

Finally, your lender will require that you pay, usually about $400, for a real estate appraiser to determine the current market value of your home. This is important; most lenders won't refinance your mortgage loan if you don't have at least 80 percent equity in your residence. If your home's value has dropped since you purchased it, you might not have this amount of equity.

If your credit, debt-to-income ratio and home value are acceptable, your lender will set a closing date for you to sign the papers that make your mortgage loan refinance official. This isn't free. It usually costs from $2,000 to $4,500 to refinance your loan, depending on its size. Most borrowers roll these costs into their monthly loan payments, which makes them far easier to pay.

Resources:

Federal Reserve Board

My FICO