Use cash for refinance or debt payment?

1 min read

EDITOR’S NOTE: Refinancing activity is soaring, so Bankrate asked personal finance columnist Dr. Don Taylor to answer some of our readers’ most pressing questions about getting a new mortgage.

Dear Dr. Don,
We are planning on refinancing our home to a fixed-rate 15-year loan. Are we better off using savings to pay down debt or having more in savings when refinancing?
— Tangi Twixt

Dear Tangi,
From a lender’s perspective, savings are useful to the extent that they’re used for a down payment.

Do you have enough equity in your home that you don’t have to worry about putting additional cash down on the refinancing? If so, you’re better off concentrating on paying down your debt while still keeping some savings as an emergency fund.

Lenders look at what percentage of your monthly income goes to housing expenses. They calculate a front ratio, which Bankrate’s glossary defines as follows:

The percentage of monthly before-tax income that goes toward a house payment — a key ratio that lenders use when deciding whether to approve a mortgage application. Traditionally, lenders didn’t like it when the total mortgage payment (principal, interest, taxes and insurance) divided by gross monthly income exceeded 28 percent. Modern risk-based pricing, however, have made lenders more flexible.

Lenders also calculate what percentage of your monthly income goes toward all loans. Known as a back ratio, Bankrate’s glossary defines it as follows:

“The sum of the house payment and all other monthly debt — credit cards, car payments, student loans and the like — divided by before-tax income. Traditionally, lenders were loath to extend borrowers’ back-end ratios past 36 percent, but they often do now.”

Paying down your debts can help you qualify for a mortgage. However, you don’t have to be debt-free to get a mortgage.

Does a refinance make sense for you? Try Bankrate’s refinance calculator to find out how much you might save.