Why The 28/36 Rule Of Thumb Generally Works
The 28/36 rule of thumb provides a pretty good guide for lenders to determine how much home you can afford.
As a mortgage lender, one of our jobs is to assess risk and the 28/36 rule is a big part of that, Edelstein said. You can be approved for a mortgage with ratios higher than 28/36, as high as 50% on the back-end. However, risk goes up and in order to be approved with higher ratios, you will have to have a strong credit score and possibly a larger down payment.
So, what is included in the DTI ratios calculation of your monthly debt obligations? Any of the following payments could be factored into your DTI:
- Future mortgage payment
- Alimony and child support payments
- Loans you co-signed for
Your DTI doesnt include utilities, cable, cellphone, and insurance bills.
Shorten The Length Of Your Mortgage Term
If your original mortgage is a 30-year term , then refinancing is a good way to get to the ultimate goal of locking in a 15-year fixed-rate mortgage.
We say 15-year fixed-rate mortgages are the goal because theyre better for you than 30-year mortgages. Youll pay off your house quicker and save a ton of money since youre skipping 15 years worth of interest payments.
Now, a 15-year fixed-rate mortgage will likely increase your monthly payment a bit. Just remember to keep your new payment to no more than 25% of your take-home pay.
It all boils down to this: You want to own your home as soon as possible instead of your home owning you! Use our mortgage calculator to run your numbers and see what your monthly payment would be on a 15-year loan.
A Rule Of Thumb Revised
I mentioned the two-percent “rule of thumb” earlier. This is the most commonly offered advice on the subject of refinancing, but it is flawed advice. As the saying goes, you should only consider a refinance if you can lower your interest rate by two percent or more. People have been saying this for years, just because they read it somewhere or heard somebody else say it. Monkey see, monkey do. Forget this advice. This rule of thumb is far too general to be useful to you.
In truth, there are several factors to consider when deciding when you should refinance your mortgage loan. These factors include:
- How long you plan to stay in the house
- How much lower the interest rate will be on the new loan, after refinancing
- How much you’ll have to pay in closing costs and fees when you refinance
- Whether or not you plan to do a cash-out refinance
Once you have all of these pieces of the puzzle, you can plug the numbers into a refinancing calculator to see how much you might save. Based on these results, you’ll know if it’s a good time to get a refi. You can find plenty of these calculators online, on such websites as Bankrate.com, CNN Money and others.
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Prepare For The Appraisal
Mortgage lenders typically require a mortgage refinance appraisal to determine your homes current market value.
What to consider: Youll pay a few hundred dollars for the appraisal. Letting the lender or appraiser know of any improvements or repairs youve made since purchasing your home could lead to a higher appraisal.
Other Factors To Consider
The 1% rule of thumb doesnt consider every aspect of a mortgage. It can be worth refinancing a jumbo loan even if the new rate is less than one percentage point under your current rate, said Cohn. Jumbo loans, or non-conforming loans, were loans over $548,250 in 2021, increasing to $647,200 in 2022, and refinancing a larger loan after a 0.5% rate drop could save you a significant amount of money.
Other reasons to refinance may not result in immediate savings. If you have an adjustable rate, you may want to refinance to a fixed rate to benefit from locking the rate in permanently, suggested Cohn. Otherwise, the amount you pay each month will increase or decrease along with the current interest rate, and some mortgages even have a limit on how low your interest rate can go.
Cohn also noted that some people choose to refinance to a shorter term so they can pay the mortgage off faster. You might refinance from a 30-year to a 15-year mortgage. Refinancing can also work if you have a HELOC and want to consolidate the first and second into a new first mortgage, she explained.
When it comes to deciding whether to refinance, Cohn said, Its really a question of how long you think you’ll remain in your home and how long will it take to actually benefit from the refinancing.
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Youve Seen A Jump In Income
An increase in income can be great if youre looking to refinance to a shorter loan term. Going from a 30-year mortgage to a 15-year term can save you thousands of dollars in interest.
As in the example above, a 30-year fixed loan of $100,000 at a high credit score of 760 to 850 would result in a monthly payment of $444 and a total interest amount of $59,993 at an APR of 2.845 percent. If you reduce your loan term to 15 years, however, the APR on the same amount of loan principal and at the same credit score changes to 2.845 percent, and the total interest amount drops to $22,967 a difference of $37,026. Thats an even bigger jump in savings than by improving your credit score.
A caveat of the 15-year loan term, though, is your monthly payment increases. At a 30-year term, your monthly payment is $444. However, with a 15-year term, your monthly payment is $683. If your budget can comfortably accommodate an additional $239 a month, then this may be an excellent option for you. But if the increased monthly payment makes your budget uncomfortably tighter, you may want to consider sticking with your 30-year loan term.
With a 15-year fixed loan term, you may pay more toward your mortgage each month, but youll also see huge savings in the amount of interest you pay over the term of your loan. High-income earners or those with enough wiggle room in their budget may want to opt for the shorter loan term.
Determine The Lenders Minimum Requirements
Mortgage lenders have different qualifying requirements for cash-out refinancing, and most have a minimum credit score the higher, the better. The other typical requirements include a debt-to-income ratio below a certain percentage and at least 20 percent equity in your home. As you explore your options, take note of the requirements.
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% Refinancing Rule Vs Break
The 1% refinancing rule of thumb is a good guide, but you should weigh it against the break-even point rule of thumb. This rule of thumb is based on how long it will take you to break even on the refinancing, based upon the closing costs and savings, Cohn explained. Its the point at which youll actually start saving money after paying off your refinancing fees. Thats why you should consider how long you plan to stay in the home as part of your refinancing decision.
Lets go back to our example above about refinancing a $200,000 mortgage from 6% to 5%. Youd save $125 a month, which works out to $90 after taxes. But lets say the fees and closing costs for your new mortgage amount to $2,500. It would take you 28 months to break even if you divide your costs by the monthly savings . It may not be worth it to refinance your mortgage if you don’t plan on staying in the house that long.
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Will The Savings Be Enough To Make Refinancing Worthwhile
Youll spend an average of 2% to 5% of the loan amount in closing costs, so you want to figure out how long it will take for monthly savings to recoup those costs. This is often called the break-even point of a mortgage refinance. For instance, it would take 30 months to break even on $3,000 in closing costs if your monthly payment drops by $100. If you move during those 30 months, youll lose money in a refinance.
» MORE:Calculate your refinance savings
Think about whether your current home will fit your lifestyle in the future. If youre close to starting a family or having an empty nest, and you refinance now, theres a chance you wont stay in your home long enough to break even on the costs.
Homeowners who have already paid off a significant amount of principal should also think carefully before jumping into a refinance.
If youre already 10 or more years into your loan, refinancing to a new 30-year or even 20-year loan even if it lowers your rate considerably tacks on interest costs. Thats because interest payments are front-loaded the longer youve been paying your mortgage, the more of each payment goes toward the principal instead of interest.
Ask your lender to run the numbers on a loan term equal to the number of years you have remaining on your current mortgage. You might reduce your mortgage rate, lower your payment and save a great deal of interest by not extending your loan term.
» MORE:When to refinance into a shorter mortgage
Youd Like To Pay Off Your Loan Faster With A Shorter Term
In addition to a lower interest rate, a new loan might provide you with an opportunity to get a loan with a shorter term without your monthly payment changing too much. Its all a matter of math.
In some cases, a significant drop in interest will make a shorter loan possible, but in other cases, a shorter loan might actually be more expensive. Wed suggest using a mortgage calculator to do the math and see if a shorter-term loan makes financial sense for you.
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Mortgage Refinance Could Save Money Even If Your Loan Is New
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Millions of homeowners could benefit by refinancing their mortgages, even if they bought or refinanced as recently as May 2019. A typical refinance could save more than $150 a month.
Homeowners are getting the message. According to the Mortgage Bankers Association, refinance applications jumped 79% in the week ending March 6, compared with the previous week. Even though mortgage rates have rebounded a bit since then, millions of homeowners could save money by refinancing.
» MORE:Compare todays refinance mortgage rates
What Is Mortgage Refinancing
Refinancing a mortgage means you get a new home loan to replace your existing one. If you can refinance into a loan that has a lower interest rate than youre currently paying, you could save money on your monthly payment and interest you pay over the term of the loan. You might also be able to take advantage of a cash-out refinance, which allows you to tap into your home equity essentially as a lower-interest loan.
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Research Your Credit Score
If your credit score changed since you applied for your first mortgage loan, it might make the terms of your refinanced loan betteror worse. If your credit score has improved, youll likely secure a better interest rate on your loan. If, on the other hand, your credit score has dropped, your rate might be higher, even if theyre advertising lower rates.
Your Credit Score Has Improved
If youve been working on rebuilding your credit, refinancing could benefit you. Generally, the higher your credit score, the lower your interest rate. Keep in mind, individual lenders determine the worth of your credit score, so individuals with a score that falls above 700 typically receive the lowest rates, but it is possible for you to get a great deal even if your score is between 600 and 700.
With a loan savings calculator, you can determine your APR, monthly payment and total interest depending on your credit score, type of loan, principal loan amount and your state of residence. A 30-year fixed loan for a principal amount of $100,000 at a credit score of 620 to 639 would give you an approximate APR of 5.006 percent. This adds up to a monthly payment of $537 and a total interest amount of a whopping $93,388.
What would happen if you increased your credit score to the 760 to 850 range? Your APR would drop to 3.417 percent, your monthly payment would drop to $444, and your total interest paid would be only $59,993. Thats a difference of $33,395 simply based on credit score.
One of the most important factors that mortgage lenders take into consideration is your credit history. Even a mere one point increase in your credit score can reduce mortgage fees. Fortunately, there are plenty of methods to increase your credit score to ensure you get a great mortgage interest rate:
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Rule Of Thumb For Mortgage Refinancing
The most common reason for a mortgage refinance is to lower a mortgage loan rate. While each homeowner has their own reasons for refinancing, it is typically to save money. When a rate reduction is your goal, a good rule of thumb for a mortgage refinance, is to lower your existing interest rate by 1% or more. While a mortgage refinance is worth considering when you see this 1%+ reduction, there are other factors that need to be considered as well. When refinancing your mortgage to lower your rate and save money, you must also calculate the length of time it will take to recoup your closing costs. Be sure you plan on staying in the house long enough to recover those costs. That amount of time is your breakeven period. Simply put, your closing costs divided by your monthly savings will provide you with your break-even point. Your overall mortgage objectives and any future plans to move will always come into play when considering refinancing. If you see a new home in your near future, a mortgage refi may not be beneficial.
Other Good Reasons To Refinance
Most people who refinance their existing home loans want to save money by getting a lower monthly payment and a lower interest rate.
But there are other reasons to refinance. While your new mortgage should save you money, there are several ways a loan can do this and they dont always include a lower rate:
1. Replace an ARM
Rates on adjustable-rate mortgages will eventually start fluctuating with the broader market each year. If you have an ARM, refinancing lets you lock in a fixed rate based on current market conditions and your credit profile.
Getting a fixed-rate mortgage can protect you from the possibility of paying a lot more interest later.
Even if you end up with a higher payment on your fixed-rate mortgage at first, the loan could pay off a lot later if interest rates increase.
2. Get rid of mortgage insurance
FHA and USDA loans charge ongoing mortgage insurance fees. Homeowners pay these fees along with their monthly mortgage payments to protect mortgage lenders from losing money if they default.
In many cases, FHA and USDA homeowners keep paying mortgage insurance for the life of the loan.
But you can eliminate these fees by refinancing into a conventional loan which may not require mortgage insurance coverage. Conventional loans require private mortgage insurance , but only until the loan balance gets paid down to 80% of the original loan amount.
3. Cash out home equity
4. Shorten your loan term
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What To Watch Out For
Reducing the interest rate on your mortgage and in turn your monthly payment may seem like a no-brainer, but there a few additional things to consider before refinancing. If you are replacing a 30-year mortgage with another 30-year mortgage, you may see a reduced monthly payment, but you may actually pay more over the life of the loan. Refinancing a 30-year mortgage with another 30-year mortgage can add extra years to the amount of time you will repaying the debt. This means you will pay more in interest over the combined lives of both loans than what you expected to pay for the original loan.
A great way to avoid paying this extra interest is to refinance a 30-year mortgage to a 15-year mortgage. By taking on a loan with a shorter term you will pay off your mortgage in fewer payments, reducing the amount of interest you will pay over the life of the loan. However, it is important to note that this strategy will increase your monthly payment, since larger payments will be required to pay off your balance in a shorter amount of time. This can be a terrific strategy for people who have lived in their homes for several years and have strong enough incomes to handle an increase in the monthly payments.
