You have two basic choices when you're refinancing your mortgage to save or get money. First, if you simply refinance your existing loan to get a lower interest rate or change the terms, it is called a rate-and-term refinance. Or, second, you may want to extract some of the equity in your house—perhaps to do a renovation, pay down debts, or help pay college costs—with a cash-out loan. Here's how these two refinance options can affect your financial position.
The Basics of Mortgage Refinancing
Think of refinancing as the replacement of an existing mortgage with another, or the consolidation of a pair of mortgages into a single loan. Out with the old (mortgage) and in with the new, as they say. After the refinance, the old loan (or loans) are paid off, and a new one replaces it.
- The basic options when refinancing a mortgage are cash-out or rate-and-term refinance.
- You can extract some of the equity in your home with a cash-out refi.
- In a rate-and-term refinance, the borrower exchanges the current loan for one with better terms.
- Cash-out loans generally come with added fees, points, or a higher interest rate because they carry a greater risk to the lender.
- It may be possible to extract some cash from your refinance without incurring the extra fees of a cash-out loan by taking advantage of the overlap of funds at the end of one loan and the beginning of another.
There are plenty of reasons to consider refinancing. Saving money is the obvious one. In August 2008, the average 30-year fixed mortgage had an interest rate of 6.48%. After the financial crisis, rates for the same sort of mortgage steadily declined. By December 2012, the 30-year fixed mortgage rate was slashed nearly in half from four years earlier to 3.35%. The average annual rate for 2017 edged up to 3.99%. By 2018, it had risen to 4.54%, according to Freddie Mac. But even these higher rates could be lower than those on older mortgages that you might have.
In March 2019, mortgage rates dropped to 4.27%, a 60-week low. In the week ending March 29, 2019, mortgage applications rose 18.6%, according to the Mortgage Bankers Association. The refinance level increased 39% to 47.4% of total applications, which was the highest level since November 2016. (The biggest recent wave of mortgage refinances hit from 2011 to 2013 and 2015 to 2016, when interest rates were near record lows.) Although the refinance index dropped to 44.1% of total applications the following week, low borrowing costs and a strong job market continue to drive applications.
Historically, rates are still relatively low and that is an important reason for homeowners with older, higher-interest mortgages (or those whose home equity has risen, or who have much better credit ratings than when they originally financed their home) to look at refinancing now.
When rates are moving higher, refinancing can offer a chance to convert an adjustable-rate mortgage into a fixed-rate one, to lock in lower-interest payments before rates climb even higher. However, it is often challenging to forecast the future direction of interest rates, even for the most seasoned economists.
Cash-Out vs. Rate-and-Term Refi
There are two basic refinance loans. The simplest and most straightforward is the rate-and-term refinance. No actual money changes hands in this case, outside of the fees associated with the loan. The size of the mortgage remains the same; you simply trade your current mortgage terms for newer (presumably better) terms.
In contrast, in a cash-out refinance, the new mortgage is bigger than the old one. Along with new loan terms, you’re also advanced money—effectively taking equity out of your home in the form of cash.
You can qualify for a rate-and-term refinance with a higher loan-to-value ratio (the amount of the loan divided by the appraised value of the property). It’s easier to get the loan, in other words, even if you’re a poorer credit risk because you're borrowing a high percentage of what the home is worth.
Think carefully before obtaining a cash-out loan in order to invest, as it makes little sense to put your funds into a CD that earns 2.5% when your mortgage interest is 5% or 6%.
Cash-out loans come with tougher terms. If you want back some of the equity you’ve built up in your home in the form of cash, it’s probably going to cost you—how much depends on how much equity you have built up in your home and your credit score.
If, for example, a borrower’s FICO score is 700, the loan-to-value ratio is 76%, and the loan is considered cash-out, the lender might add 0.750 points to the up-front cost of the loan. If the loan amount were $200,000, for example, the lender would add $1,500 to the cost. (Every lender is different.) Alternatively, the borrower could pay a higher interest rate—0.125% to 0.250% more, depending on market conditions.
Why the tougher terms? Because cash-out loans carry a higher risk to the lender, according to Casey Fleming, mortgage advisor, C2 Financial Corporation and author of The Loan Guide: How to Get the Best Possible Mortgage. According to Fleming,
“Statistically, a borrower is much more likely to walk away from a home if he gets in trouble if he has already pulled equity out of it. It is particularly true if he has pulled out more than he initially invested in the down payment. Consequently, any loan that is considered cash-out is priced higher to reflect that risk, until there is so much equity that the borrower isn’t likely to walk away anymore.”
But a higher credit score and lower loan-to-value ratio can shift the numbers substantially in your favor. A borrower with a credit score of 750 and a loan-to-value ratio of less than 60%, for example, won’t be charged any additional cost for a cash-out loan; lenders believe he or she is no more likely to default on the loan than if doing a rate-and-term refi.
Your loan may be a cash-out loan, even if you don’t receive any cash. If you’re paying off credit cards, auto loans, or anything else that wasn’t originally part of your mortgage, the lender probably considers it a cash-out loan. If you’re consolidating two mortgages into one—and one was originally a cash-out loan—the new consolidated loan will also be classified as cash-out.
One more reason to think twice about cash-outs: Doing a cash-out refinance can negatively affect your FICO score.
The number of mortgage refinances that were cash-out loans in Q4 of 2018.
More Americans Choosing Cash-Out Refinance
Although many personal finance experts would advise against stripping your home of its equity in a cash-out refinance, recent data shows that many Americans are choosing this loan type. Freddie Mac’s quarterly refinancing statistics demonstrated that, in the fourth quarter of 2018 (released in March 2019), cash-out borrowers represented 83% of all refinance loans, the highest since the third quarter of 2007.
Source: Freddie Mac, Quarterly Refinance Report, 2018
Many of these refinances were not for a rate reduction. The most common uses of the funds were home improvements or to pay bills and debts. Other reasons cited for cashing out included paying for college expenses, auto purchases, and business investments.
Source: Freddie Mac, Quarterly Refinance Report, 2018
An Interesting Mortgage-Refinancing Loophole
With the help of your mortgage broker, you may be able to generate a little cash from your refinancing without it being considered a cash-out loan (and generating the extra fees that come with it). Basically, it works by taking advantage of the overlap of funds at the end of one loan and the beginning of another. It's a complicated process that will affect any escrow accounts, so pay close attention to how Fleming describes it:
“You are allowed to finance closing costs in a rate/term refi. Most lenders allow those closing costs to include prepaid expenses, such as prepaid interest, the unpaid accrued interest on your existing mortgage, the money necessary to pre-fund your escrow account, and even property taxes and insurance if you time it right.
“When you refinance, you pay the accrued interest on your existing mortgage up to the day it is paid off. You prepay your interest on your new loan from the day you fund until the first of the next month, and then you don’t make a payment the next month. Therefore, you have financed one month’s interest on your mortgage within the new loan.
“If you have an impound (or escrow) account to pay insurance and taxes with your existing mortgage, then your existing lender is holding some of your money—at least a couple of months of taxes and insurance each. When you refinance, your new lender will need some money on hand when your tax and insurance bills come due, so they will ask for some money upfront. You can usually finance this.
“Then, after your loan closes, your old lender—who is holding some of your money—sends you a check equal to the balance of your escrow account when you paid off that loan. Cash!
“Also, because some of the fees change a little up until funding, most lenders allow a little bit of cushion—up to $2,000 in cash back in escrow without the loan being considered cash-out.
“What all this means is that you can finance ‘costs’ that aren’t really the cost of originating the loan but rather represent the cost of having the loan. On a $200,000 rate/term loan, it would be very feasible to generate about $4,000 in cash—under the right circumstances, if it were structured carefully—without paying a cash-out penalty.”
The Bottom Line
Your responsibility as a borrower is to have enough knowledge to discuss options with your lender. For most people, avoiding the added cost of a cash-out loan is the best financial move. If you have a specific reason for taking cash out of your home, a cash-out loan may be valuable, but remember that the extra amount of money you will pay in interest over the life of the loan can make it a bad idea.