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

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.

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.