For many homeowners, a major incentive of refinancing is the potential to lower the interest rate and monthly payments on their mortgage.

With the average rate on a 30-year fixed-rate mortgage hovering around 3% in April 2021, still close to the all-time low of 2.65% reached in January 2021 and far below the 5-10% rates that were the norm until a decade ago, millions of Americans could substantially lower their rate with a refinance.

Of course, refinancing is about more than just what’s good for the average person. Your rate depends on a range of variables related to your borrowing profile and home. Another thing to be aware of is that in addition to closing costs, you may have to pay a mortgage refinancing fee worth 0.5% of the loan amount.

The main factors that determine your interest rate

Whether you’re applying for a purchase loan or refinance, your rate depends largely on your borrowing profile and home value. When it comes to refinancing, these are the main things lenders look at.

• Credit score. Your credit score changes regularly based on factors such as your handling of monthly payments and your outstanding balance on loans and credit cards. If your credit score has improved since you took out your initial mortgage, this puts you in a better position when applying for a refinance.
• Loan-to-value ratio. LTV is calculated by dividing your principle loan balance by the current value of your home. If, for example, an appraisal shows your home is currently worth $300,000 and you have $240,000 remaining on mortgage, then your LTV will be 80%. The lower your LTV ratio, as in the less you have owing on your home, the better your chance of scoring a low interest rate.
• Debt-to-income ratio. DTI is calculated by dividing your overall debt payments (on your mortgage and other loans and credit cards) by your gross monthly income. The highest DTI permitted on a qualified mortgage is 43% although most lenders only accept up to 36%. Like credit score and LTV, DTI is a measure of how risky you are as a borrower. The lower your DTI, the better your ability to obtain a low interest rate on your refinance.

How closing costs affect your refinance

Lenders talk about refinancing and purchasing as two different things, but they are essentially the same thing. A refinance is just a new mortgage that replaces the one you originally obtained when you purchased your home. The approval and underwriting process is similar, and it involves more or less the same closing costs.

Closing costs can range from 2-6% of the loan amount, so that a refinance of say $300,000 would include closing costs of $6,000 to $18,000. These can be paid upfront or added to your monthly payments (with interest) as part of a no closing cost refinance.

Closing costs consist of lender and third-party fees such as:

• Application fee. For opening a refinance application.
• Origination / underwriting fee. For the work done by the lender to process and underwrite the loan.
• Appraisal fee. For a third-party appraisal to calculate the current market value of your property.
• Survey / inspection fee. For a third-party inspection to ensure the home is structurally sound.
• Title search. For a title search by a third party to ensure there are no ownership disputes or liens on your property.
• Title insurance. To protect the lender in the event of an ownership dispute or lien during your repayment term. This is typically an upfront fee.
• Private mortgage insurance. If your LTV is above 80%, you will probably have to pay PMI. The first year’s premium is usually required upfront.
• Homeowners insurance. Home insurance coverage is a requirement of all lenders. The first year’s premium is usually required upfront.
• Other third party fees. The mortgage process often involves the participation of various third parties such as escrow agents and attorneys.
• FHA / VA fees. Additional closing fees usually apply for refinancing with a government-backed loan such as an FHA loan or VA loan.

Understanding the new FHFA refinancing fee

In addition to the closing costs shown above, most homeowners are now subject to the Federal Housing Finance Agency (FHFA)'s new mortgage refinancing fee, know officially as the adverse market fee, which was implemented on Dec 1, 2020.

Fannie Mae and Freddie Mac, the government-sponsored enterprises that guarantee most mortgages via the secondary market, pushed for this fee to help them cover billions of dollars of projected losses due to Covid-19. This fee adds a charge of 0.5% of your loan balance to your total refinance costs. For example, if you’re refinancing a loan of $300,000, this new fee means you’ll owe an additional $1,500.

The following borrowers are exempt:

• Borrowers with a principle balance less than $125,000.
• Borrowers refinancing with government-backed loans such as VA and FHA loans.
• Borrowers refinancing with portfolio lenders (banks or other institutions that do not sell loans in the secondary market and are therefore not bound by Fannie Mae and Freddie Mac guidelines).

Bottom line

In theory, refinancing could save you a lot of money on your mortgage. However, it’s important to take into account the different variables, such as your own borrowing power and the significant closing costs. For our in-depth guide to calculating if a refinance makes sense, click here.

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