If you are paying a mortgage on your home, you may have heard about refinancing your mortgage to take advantage of lower rates or get cash out to make repairs or remodel your home. However, not every homeowner will benefit from refinancing their homes. There are a few things you should consider before you pursue this type of loan.
The Loan Period
When you refinance your home loan, you start at the beginning of the loan, so if you have paid 10 years on a 30-year mortgage and you refinance, you start again at year one. Although you can refinance your loan for a shorter period, it will often cost you more per month rather than less. Any monthly savings you expected due to a lower interest rate may be eliminated. Therefore, make sure your budget can handle a higher payment if you choose a loan with a shorter term.
Other than the loan period, you may wonder what to consider when refinancing your mortgage. One significant benefit of a refinance is that you can cash out your equity. For example, if your home has increased in value or you have paid a significant amount of the principle, increasing your equity, you can use a cash-out refinance to make repairs, remodel, pay off consumer debt, invest in property or pay for any other project you choose. This money is yours free and clear, and the amount you take out is added to your new loan during the refinancing process. For example, if you have a $400,000 home with $150,000 in equity, you may be able to refinance up to $320,000, allowing you to receive up to $70,000 in cash. Your original mortgage is paid off, but you are responsible for the new mortgage of $320,000, which will likely raise your monthly payment.
As you consider refinancing your loan, calculate all the costs. Lower refinance home loan rates are only one of the benefits you may receive. If you have more than 20 % equity in your home, and don’t cash it out, you can drop your private mortgage insurance, which is typically 0.5 % to 1.5 % of your home loan.
Although you may save on your interest rate and insurance requirements, you still may not save money overall due to your pay closing costs and other fees. For example, you may pay up to $300 to apply for the loan, 800 for an appraisal, $500 to prepare your documents, $900 to complete a title search and $850 to get your home inspected. You may also be required to pay loan origination and recording fees of 1.5 % of the loan value and up to $500, respectively. In addition, you can lower your interest rate further by paying discount fees of up to three per cent of your mortgage principle.
These closing costs add up and should be weighed against your interest savings. For example, if your closing costs are $6,000 and you will save $175 per month based on the lower interest rate, your payback period on the closing costs is only 35 months. In this case, if you decided to move in a few years, you would still come out ahead. However, if you are only saving $57 per month, your payback period is almost a decade. If you don’t plan to stay in your home this long, a refinance may not be cost effective.
Before you refinance your home loan, you need to understand your statistics. For example, what is your credit score, annual income and debt-to-income ratio, and how much equity do you have in your home? Although your credit score was adequate for you to gain approval for your initial loan, it may not be high enough for a refinance loan because many lenders have adjusted their loan approval standards. If your credit rating is not high enough, you may not be eligible for the lowest interest rates available.
The debt-to-income ratio requirement has also been tightened in recent years. However, your longevity at your current employer and income may offset some of these requirements. Be aware that your lender doesn’t want your mortgage to be more than 28 % of your gross monthly income.
You have a lot to consider before pursuing a refinance loan. Make the best decision by doing your due diligence and learning more about these loan opportunities, costs and requirements.