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Refinance Guide
Getting Ready to Refinance
Reasons to Refinance
The first step in deciding whether you should refinance is to establish your goals. The most common reasons for refinancing a mortgage are to take cash out, get a lower payment or shorten your mortgage term.
Take Cash Out
You can also do a cash-out refinance, which allows you to use the equity you’ve built in your home to borrow money. Homeowners often reinvest that cash out back into their home to make renovations or repairs that boost their home’s value. Taking cash out can also be useful if you need extra money for expenses such as education or medical costs and don’t have access to other funds.
So, how exactly does a cash-out refinance work? Let’s say your home is worth $300,000 and you have $100,000 left on your current mortgage. That means you have $200,000 in home equity that you can borrow against. In this instance, you could choose to do a cash-out refinance for $30,000 of your equity and your new mortgage would be for $130,000.
Since lenders view cash-out refinances as riskier than rate-and-term refinances, interest rates are generally higher. However, you may still be able to get a better interest rate than your current financing, particularly if rates have dropped or your credit score has improved since you got your original mortgage. To be eligible for a cash-out refinance, most lenders also require that your loan-to-value ratio (LTV) stays at or below 80% post-refinance (for a single-unit primary residence; maximum LTVs for other properties may vary). You can calculate your cash-out refinance LTV using this simple equation:
Get a Lower Payment
If rates have dropped since you got your original mortgage, you may be able to refinance into a loan with a lower rate. Doing so may lower your monthly payments, meaning you may also pay less over the life of your loan. To find out if you stand to save on your monthly payments, you can check today’s rates in seconds.
Alternatively, if rates haven’t dropped significantly but you have had or anticipate a decrease in income, you may be able to lengthen your loan term to pay off your loan more gradually. For example, if you switch from a 15-year fixed-rate mortgage into a 30-year fixed-rate mortgage, you can make lower monthly payments. However, it’s important to note that you’ll also have to pay interest for a longer period of time.
Finally, if you’ve paid off a significant amount of your mortgage or your home’s value has increased, then your loan-to-value ratio (LTV) will be smaller. A smaller loan amount compared to the value of your home means that the loan is considered lower risk to the lender—which can help you get a better rate. If you’ve recently passed the 20% mark for equity in your home and you’ve been paying for private mortgage insurance, you can also refinance to cancel your mortgage insurance.
Shorten Your Mortgage Term
Shortening your mortgage term is a great way to save money on interest. Often, shortening your term means you’ll receive a better interest rate. A better interest rate and fewer years of payments mean big interest savings in the long run.
So how does this work? Let’s look at an example. Say your loan amount is $200,000. If you got a 30-year loan with a 3.5% interest rate, you would pay approximately $123,000 in interest over the life of the loan. However, if you cut your term in half, you would pay about $57,000 in interest over the life of the loan. That’s a difference of $66,000 – and it doesn’t even account for the fact that the shorter term would provide you with a lower interest rate (and more savings).
An important thing to know about shortening your term is that it may increase your monthly mortgage payment. However, less of your payment will go toward interest, and more of it will go toward paying down your loan balance. This allows you to build equity and pay off your home faster.
How long should I own my home before refinancing?
In most cases, you’ll need to be in your current home for at least a year before getting a significant financial benefit from refinancing.
Things You Need to Evaluate Before Refinancing
Once you have a clear goal in mind, you’ll want to evaluate your financial situation. There are four keys things to look at: your credit score, your monthly mortgage payment, the value of your home and your debt-to-income ratio (DTI).
Your Credit Score
Your Monthly Mortgage Payment
Knowing how your monthly mortgage payment fits into your budget will help you evaluate your options. If you’re taking cash out or shortening your term, for instance, it’s a good idea to know how much wiggle room you have in your budget for a higher monthly payment. If your goal is to get a lower monthly payment, it’s important to decide how much you need to lower your payment for the refinance to be worthwhile.
The Value of Your Home
Before you refinance, you’ll want to do a bit of research to estimate how much your house is worth. Your lender can’t lend you more than the home is worth, so an appraisal value that comes back lower than expected can impact your ability to refinance – especially if you’re looking to take cash out or remove mortgage insurance.
The best way to estimate your home value is to check the sale prices of similar homes near you. The more recent the sale, the better.
Knowing the value of your home can tell you how much equity you have. To figure this out, just subtract your current mortgage balance from the estimated value of your home.
Your Debt-to-Income Ratio
Another factor to take into consideration is your DTI. DTI is all your monthly debt payments divided by your gross monthly income. DTI is one way lenders measure your ability to repay the money you’re borrowing.
If you were paying $1,000 a month for your mortgage and another $500 for the rest of your debts (such as credit card debt, auto loans and student loans), your monthly debts would equal $1,500. If your gross monthly income was $4,500, then your DTI ratio would be 33%.
Most lenders require a DTI of 50% or lower, and the maximum DTI varies by the type of loan you get. A DTI that’s too high could impact your ability to refinance or limit your refinance options.
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