At a glance...
Your decision to refinance your home loan can be due to certain common reasons such as taking cash out, getting a lower payment, or to shorten your mortgage term.
Once you have made the decision to refinance your home loan, you will need to evaluate your financial situation before refinancing. The four main factors you should keep in mind are your credit score, your monthly payment, your Debt-to-Income (DTI) ratio, and the value of your house.
Most people would choose to refinance their mortgages after owning their current house for at least one year in order to get a significant financial benefit.
Reasons For Refinancing Your Home Loan
Now, for a better idea on how you should go about refinancing your mortgage, you will need to have a better idea of what refinancing entails. Let’s start with the reasons for refinancing before moving on to what you need to evaluate your financial situation.
The reasons for refinancing your Home Loan could be due to:
1. Wanting to take cash out
A great way to use the equity you have in your house is to refinance your mortgage. You can refinance or a higher loan amount than what you currently owe, and keep the difference with a cash-out refinance. By doing that, any proceeds you end up receiving will be tax-free.
Plenty of homeowners tend to use the cash from their house to pay off high-interest credit card or student loan debts. Financing home improvements, education, or anything you may need such as emergencies can also be done by taking cash out.
This is because mortgage interest rates tend to be much lower than interest rates with other kinds of debts. As such, a cash-out refinance can be a beneficial method to consolidate or pay off any debts you owe. Plus, mortgage interest is tax-deductible, whereas the interest for other debts typically aren’t tax-deductible.
On the other hand, if you have been paying on the loan long enough to build equity, you might be able to take cash from your house. If your property value has increased, then you might be able to do a cash-out refinance. This is because the higher the value of your house, the more your lender can provide in terms of money to finance it.
2. Getting a lower mortgage payment
Refinancing can help lower your payment, which in turn can help you create more room in your financial budget for other goals you may need the money for. There are a few methods you can use to lower your payment by refinancing.
The first method is to refinance with a lower rate. If the current rates are lower than when you first purchased your house, it’s a good idea to talk to your lender and see what your interest rate could be. Getting a lower rate can help with big interest savings in the long run because it lowers the interest portion of your monthly payment.
The second method is to refinance in order to be rid of mortgage insurance, which is a monthly fee that you pay to protect your lender should you default on the loan. Do note that a mortgage insurance is typically only needed when you put down less than 20%. You could end up saving hundreds of dollars each month through refinancing to stop paying a monthly mortgage insurance.
The third method you can use to get a lower payment is to change your mortgage term. By stretching out your payments over more years via the lengthening of your term, you can pay a smaller payment in return.
Besides these methods, you can also check in with your lender to see if there are any other methods to help you get a lower payment that is suitable for your budget.
3. Shortening the mortgage term
Another great way you can save money on interest is by shortening your mortgage term. Most of the time, you will get a better interest rate when you shorten your mortgage term, and a better interest rate means that you will get big interest savings in the long run because of fewer years in terms of payments.
For example, if your loan amount is $200,000 and it is a 30-year loan with a 3.5% interest rate, you will be paying approximately $123,000 in interest over the life of the loan. However, if the mortgage term is cut in half, then you will be paying approximately $57,000 in interest over the life of the loan.
That amounts to a huge difference of $66,000! Plus, this doesn’t even take into account the fact that a shorter term will be able to provide a lower interest rate which allows for more savings.
Although shortening your term may seem entirely beneficial, you should take note that shortening your mortgage term may increase your monthly payment instead. However, you can build equity and pay off your house earlier because while less of your payment will be going to the interest, more will be used to pay off your loan balance.
Criteria To Be Evaluated Before Refinancing Your Home Loan
Before refinancing your mortgage, you should evaluate your financial situation based on your:
1. Credit score
Nowadays, it’s much easier to find out what your credit score is for free thanks to a variety of online resources. With the knowledge of your credit score, you can better understand what are the mortgage refinancing options you are eligible for and what suits you best.
2. Monthly mortgage payment
Having an understanding and knowledge of how your monthly payment can fit into your financial budget is a great help when you need to evaluate your possible options.
For example, if you plan on taking cash out or shortening your mortgage term, it is good to have an idea of how much space you have in your budget for a higher monthly payment. It’s important to decide how much you will need to refinance in order to get a lower monthly payment that’s worth it.
3. House’s value
Before refinancing, it’s also important for you to do some research in order to estimate the value of your house. This is because your lender cannot lend you more than the value of your house, thus an appraisal value that is lower than expected may affect your refinancing options. This is especially important if you intend to take cash out or remove mortgage insurance.
You can estimate your house’s value by checking the sales prices of similar houses in an area near you. It is better if you can check the sales prices of recent sales instead of older houses for a better idea of the value.
To know how much equity you have, you will need to know the value of your house. By subtracting your current mortgage balance from the estimated value of your house, you can figure out the value and equity.
4. Debt-to-Income (DTI) ratio
Last but not least, one other factor you should consider is your Debt-to-Income (DTI) ratio. Your DTI ratio is calculated by having your monthly debt payments be divided by your gross monthly income. It is one way for lenders to measure your ability to repay the amount you intend to borrow.
For example, if you were to pay $1,000 per month for your mortgage and another $500 for other debts including your credit card debt, auto loans, and student loans, then your monthly debts would amount to $1,500.
If your gross monthly income amounts to $4,500, then your DTI ratio would be at 33%.
If your DTI is too high it can affect your ability to refinance and limit your options. Thus, most lenders will require a DTI ratio of 50% or lower, with the maximum DTI varying by the type of loan.
To sum it up, now you can have a better idea of how you should go about refinancing your home loan after evaluating your finances.
After considering the possible reasons such as taking cash out, getting a lower payment, or to shorten your mortgage term, you can make the decision to refinance your home loan. And with the main factors that affect your financial situation such your credit score, your monthly payment, your Debt-to-Income (DTI) ratio, and the value of your house considered, you can refinance your mortgage with ease.