Seven steps to take before you refinance

If you're considering refinancing your home, here are a few essential steps to take before signing on the dotted line.

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Are you taking note of the low interest rates and wondering if refinancing might be a good option for you?

If done right, it could save you a significant amount of money.

But before you jump into this process, there are some important steps you should take to make sure refinancing is in your best financial interest, says Chris L. Boulter, president of Val-Chris Investments, Inc., a company specializing in residential and commercial loans. This includes checking your credit score and knowing the value of your home, among other things.

Want more details? Read on for specific steps you'll want to take before you refinance.

[Click to compare mortgage rates from multiple lenders on Yahoo! Homes now.]

#1 - Understand What Refinancing Can Do for You

Refinancing your home is a big move, so you should know exactly what it is and how it could benefit you.

Essentially, refinancing is the process of getting a new mortgage to replace your existing one. The new loan, says Boulter, pays off the first and could give you a new interest rate, new monthly payment, and a new term length.

Usually, says Boulter, people refinance to reduce their interest rate (also known as the price of borrowing money) on their loan. This means that when you reduce your interest rate, you'll also lower the cost of borrowing money and therefore save money.

But that's not all. Refinancing could also help you go from a 30-year loan term to a 15-year loan (or vice-versa), switch from an adjustable-rate mortgage to a fixed-rate mortgage, consolidate your first and second mortgages, and much more.

So, do your research, contact a mortgage lender, and find out how you could benefit from refinancing.

[Think refinancing might be right for you? Click to compare rates from multiple lenders now.]

#2 - Check Your Credit Score

Do you know what your credit score is? If not, you should probably get on top of it because having a good credit score is important when it comes to refinancing, says Boulter.

Particularly, your credit score determines whether you qualify for refinancing, as well as what kind of interest rate you'll get. Generally, the higher the score, the lower your rate, says Boulter. And to get the historically low rates now available, you'll need a very good score: 720 or above, he adds.

In case you're wondering, that's on a scale of 300 to 850, according to the Fair Isaac (FICO) scale, which Boulter says is the one that most banks use.

So, what happens if you're not thrilled with your score? You can still make strides to help improve it. In fact, 65 percent of your credit score is determined by two factors: your payment history and the amounts you still owe, according to the FICO website.

[Has your credit score improved? Click to compare rates from multiple lenders now.]

So, it may take time to build up your score into the positive, but if you make sure to pay all bills on time and pay down as much debt as possible, you'll definitely be going in the right direction.

You can get one free copy of your credit score every year. The only authorized website to fill orders for the free annual credit report is annualcreditreport.com, says the Federal Trade Commission, a federal agency that prevents business practices that are unfair to consumers.

#3 - Check Your Equity

Equity is something else you'll want to become familiar with, too. Why? Because equity - the difference between the current market value of your home and the amount you still owe on your mortgage - plays a part in determining whether or not you can refinance.

Lenders normally want you to have at least 20 percent equity in order to refinance, according to Boulter. He says this is because of the real estate market downturn, and the fact that lenders are cautious when lending money with real estate as collateral, which is exactly what they do when you refinance your home.

The good news is that there are still options out there for those with little or no equity, according to Making Home Affordable (MHA), an official program of the Department of Treasury & Housing and Urban Development. 

#4 - Shop Around

You probably shop around for the best price on bread, so when it comes to a mortgage - which could be hundreds of thousands of dollars - it makes sense to shop for the best interest rate.

However, according to Boulter, don't expect to find a lot of difference in rates. Because of recent laws and a banking industry with fewer companies, he says there is less variety in rates.

"That said, it certainly makes sense to get a second opinion on the terms that have been negotiated," he says.

[Want to shop around for the best interest rates? Click to compare rates from multiple lenders now.]

And even if it's just the slightest different in interest rates, when it comes to borrowing hundreds of thousands of dollars for 15 or 30 years, a small difference in the rate could mean a big difference in cost over time.

#5 - Learn How Much You Will Lower Your Interest Rate

For you, the whole point of refinancing is probably to save money by lowering your interest rate, which, remember, is essentially the price you are paying to borrow the money.

And because there are costs and fees associated with refinancing (more on that in #6), you need to make sure you lower your rate enough to make refinancing worthwhile. Generally speaking, if you can lower your rate by three-quarters of a percent, refinancing is worth considering, says Boulter.

To get an idea of what your new interest rate might be, Boulter says that most lenders will give good faith estimates that spell out costs, fees, and interest rates - with no commitment on your part.

One important point to note, says Boulter, is that the more fees and costs you pay up front or out of pocket, the lower your rate may be. Similarly, you could also have the option to take a lower rate and then add the amount you would pay for fees and costs into the amount you borrow.

[Want to see what kind of interest rate you'll get? Click to compare rates from multiple lenders now.]

#6 - Understand Your Closing Costs

Did you think that paying interest on the loan was the only price you had to pay?

Well, your bank thinks otherwise. There are other costs and fees associated with your loan, known as closing costs, and it's important to make sure that the refinancing savings outweigh them.

To help you better understand what closing costs involve, here's a brief breakdown of some of the more common major costs and fees, although they could change from lender to lender:*

Loan Origination Fee: Your lender charges this to cover such things as attorney fees, document preparation fees, notary fees, and more. It might be called an underwriting fee, administrative fee, or processing fee. The average cost is $2,537 with a 10 percent down payment.

Application Fee: Your lender charges this fee to cover processing your loan request and checking your credit. The median cost is $365.

[Want to compare fees from multiple lenders? Click to compare rates now.]

Points: These represent a one-time fee from the lender. One point equals one percent of the amount of the loan. For example, one point on a $100,000 loan is $1,000. These fees are usually between .5 and 1 percent, according to Boulter.

Appraisal Fee: This is a determination by a professional appraiser of the worth of your property. The lender wants to make sure it is worth at least the loan amount. The Federal Reserve notes that the median cost is $292, but Boulter says it could be up to $700.

Lender-Required Home Inspection Fees: Depending where your home is located, the lender may want inspections of the house's systems and structure. This cost is estimated to be anywhere from $300 to $500.

Private Mortgage Insurance (PMI): If you are borrowing more than 80 percent of the market value of the home, or in other words, if your down payment is less than 20 percent, the lender will usually require mortgage insurance. This insurance covers the lender's loss if you don't make the mortgage payments. The estimated cost is $50 to $100 per month.

#7 - Determine How Long You Plan to Stay in Your Home

Is this your dream home? The one in which you want to stay until you're old and gray? You should know, because the answer can help you determine whether refinancing is the right move for you.

Basically, says Boulter, if you're planning to stay in your home for at least a year to two years after refinancing your mortgage, it's probably worth it to refinance.

Why? Because of those closing costs we discussed earlier. Essentially, since getting a new loan costs money, it takes time for the savings to outweigh the costs. For example, let's say you borrow $300,000 and it costs 1.5 percent in closing costs. That's $4,500. If your monthly payment goes down by $300 per month, it will take 15 months to pay for those closing costs in savings.

*Unless otherwise stated, all costs and fees information according to "A Consumer's Guide to Mortgage Settlement Costs" published by the Federal Reserve Board, the main governing body of the Federal Reserve System which oversees national monetary policy and the banks.

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