Table of Contents
Got a conventional mortgage loan you’re not happy with? Have financial circumstances changed since you first took out this loan? Desire more cash flow, or yearn to save thousands on interest? You could be a great candidate to refinance your conventional mortgage.
Trust in this handy guide to help you navigate a refinance, including good reasons to refi, lender requirements, and the steps involved.
Why refinance your conventional loan?
There are several common reasons borrowers pursue a conventional loan refinance. Refinancing can:
- Lower your interest rate if rates have dropped, resulting in significant savings over the life of your loan.
- Decrease your monthly payments if you lock in a lower rate and/or extend your loan term, providing more cash flow for other expenses or investments.
- Help build home equity more quickly and save significant dollars on overall interest if you refinance to a shorter loan term, such as moving from a 30-year to a 15-year mortgage.
- Provide an opportunity – if you opt for a cash-out refinance – to tap into your home equity for major expenses like home improvements, education, or debt consolidation.
- Enable you to switch from an adjustable-rate mortgage (if you currently have one) to a fixed-rate mortgage, giving you more stability and predictability in your payments.
Financial planner Reagan Smith with Millennial Wealth LLC explains that a refinance is especially worth it if you can lower your interest rate by at least 1 percentage point (100 basis points).
“Let’s say you bought a house in 2023 and obtained a 30-year mortgage with a fixed interest rate of 6.81%, which was about the average rate charged last year,” she says. “If interest rates were to decrease by 1 percentage point later this year, you could reduce your monthly payment significantly.”
Case in point: Assume you purchased a $425,000 home last year at 6.81% over 30 years and currently pay about $2,219 monthly in principal and interest. If you refinanced to a new 30-year conventional loan at a 5.81% fixed rate, you’d cut about $245 from your monthly payment and pay about $61,477 less in interest over those 30 years.
“While lowering the interest rate is the main reason people pursue a rate and term refinance, there are a number of worthy scenarios where refinancing makes sense,” says Steven Parangi, owner of Alpine Mortgage. “For example, if you are currently paying private mortgage insurance on your conventional loan because you did not originally have at least a 20% down payment, and your property will now appraise for much higher, a refi may be able to eliminate your PMI.”
Additionally, if you are struggling with high-interest debt, a cash-out refinance can be a shrewd way to consolidate these obligations into a single lower-interest loan.
“This can lead to lower monthly payments and potentially save thousands in interest charges over time,” Parangi adds.
What to expect when you refinance
Here’s the good news about a conventional loan refi: The process should be fairly straightforward and similar to what you went through when you originally got your mortgage loan.
“That’s because both the old and new loan will have roughly the same qualification criteria that lenders look for, including minimum credit score needed, income requirements, and debt-to-income (DTI) requirements,” notes Parangi.
The time it takes to close may also be shorter for a refi than a purchase loan. The former can often be accomplished in as quickly as 20 days or so, while the latter can sometimes take up to 45 days.
Also, since you originally qualified for a conventional loan, you have a solid chance of getting a new one. Why? Because your conventional loan was given by a private lender and not insured or guaranteed by the government as an FHA, VA, or USDA loan would be.
“The government does not back conventional loans, so you are not required to pay mortgage insurance premiums as you would with an FHA loan, obtain a Certificate of Eligibility (COE) as you would need for a VA loan, or worry about stringent income limitations and rural property restrictions for a USDA loan,” adds Smith.
One more distinction to make: Conventional loans are often associated with Fannie Mae and Freddie Mac, the two major government-sponsored enterprises that ultimately purchase and guarantee most mortgages in the United States. Conventional loans that meet the guidelines set by Freddie Mac and Fannie Mae are known as conforming loans, which have guidelines and requirements when it comes to loan limits, credit score requirements, and DTI ratios.
“However, not all conventional loans conform to Fannie Mae and Freddie Mac guidelines,” Parangi points out. “Jumbo loans, for example, exceed conforming loan limits and have different qualification criteria.”
What’s Required
Eager to refinance? Here are the major eligibility requirements and guidelines you’ll likely need to meet to qualify for a refi loan.
Income/Assets
There isn’t a minimum income requirement to refinance a conventional mortgage, but lenders usually assess your debt-to-income (DTI) ratio (more on this next) when reviewing your application.
“The loan underwriter will review your monthly gross income from all sources, including wages, salaries, bonuses, commissions, gig work, etcetera. This is to ensure that your earnings are stable and consistent enough for you to make your mortgage payments,” Smith says. “Having sufficient funds and income can help you secure your refinance loan.”
Your chosen lender will verify your income via paystubs, W-2 forms, and tax returns requested.
DTI Ratio
Your DTI ratio is a measure the lender will use to evaluate your ability to manage monthly payments and repay debts by comparing total monthly debt payments to gross monthly income. To calculate DTI, add up all your monthly debt obligations, including mortgage payments, car loans, credit card payments, student loans, and any other recurring debt.
Then, determine your gross monthly income, which is your income before taxes and deductions and can include salary, wages, bonuses, and other consistent income sources. Finally, divide the total monthly debt payments by the gross monthly income and multiply the result by 100 to get the percentage DTI ratio.
Most lenders allow a maximum DTI of 45% on a conventional refinance loan.
“While there are no hard DTI limits on refinancing, you will almost definitely need less than 50% to be considered at all, and less than 36% to get the best rates and terms,” suggests Martin Orefice, CEO of Rent To Own Labs.
Credit Score
Your lender will also scrutinize your three-digit FICO credit score, which is a reflection of your creditworthiness.
“A minimum credit score of 620 is usually required, although higher scores may be needed depending on other risk factors on the loan,” says Parangi.
LTV Ratio
Your loan-to-value (LTV) ratio is used to assess the risk of lending money for a property by comparing your loan amount to the appraised value of your home. A higher LTV ratio indicates a higher risk for the lender.
To calculate LTV, determine the total loan amount and the property’s appraised value (a professional appraisal is usually required here). Then, divide the loan amount by the appraised value and multiply by 100 to get your percentage.
If the home is your primary residence, the maximum LTV can be 97% for a conventional loan refinance. If your property is a second home, the max LTV is usually around 90%.
“For a cash-out conventional mortgage refinance, you’ll need an LTV ratio of 80% or lower, meaning you need to retain at least 20% equity in your home,” Orefice says.
Home Equity
If you originally made less than a 20% down payment on your recent home purchase, chances are you are paying private mortgage insurance (PMI) premiums. PMI should drop off automatically or upon request when you reach 20% equity.
But even if you’ve not yet crossed the 20% equity threshold, refinancing could eliminate your PMI if your home’s value has increased significantly (as demonstrated by a professional appraisal).
Property Details
Again, a fresh appraisal will likely be needed to confirm that the value of your home supports the refinance loan amount.
“The condition of your property will also be assessed during the appraisal process to ensure it does not have any repairs needed or have any health or safety issues,” adds Parangi.
Other Requirements
In addition to all of the above, your lender will require that your property have a clean title, sufficient homeowners insurance coverage, and no history of recent foreclosure or bankruptcy.
Recent changes to be aware of
Keep in mind that, over the past year, some lenders have tightened their lending requirements due to economic uncertainty, according to Parangi. That means you should prepare to present yourself as a worthy refinance borrower candidate by checking on your credit score, DTI, LTV, and overall financial status before applying for a refinance loan to improve your odds of getting approved.
The refinance process
The steps involved with refinancing a conventional mortgage loan are nearly identical to what you went through when you got your original mortgage loan. These include:
- Shop around and choose a refi lender. It’s best to get several rate quotes and compare rates and loan deals carefully.
- Submit a loan application, along with the necessary documentation requested.
- Have your home professionally appraised, which the lender will most likely require and charge you for.
- Await an underwriting decision. Here, the lender will review your application, documentation, and appraisal report in making its decision.
- Close on the new refinance loan. On your closing date, you will review and sign all your loan documents and pay closing costs.
- Begin making payments on your new refinance loan, which often start one month after closing.
The Bottom Line
It’s wise to familiarize yourself with current borrower requirements if you seek a conventional loan refinance. To qualify, your numbers need to add up and mesh with what the lender necessitates.
Do your homework well before applying for a refi loan and ensure that your credit score, DTI, LTV, and other metrics are within acceptable guidelines.