When refinancing a mortgage, essentially, you have two choices. If you refinance your existing loan to get a lower interest rate or change the terms, it is called a rate-and-term refinance. If you want to extract some of the equity in your home—perhaps to do a renovation, pay down debts, or help pay college costs—you may take a cash-out loan.
But it's important to understand how these two refinance options can affect your financial position.
- The basic options when refinancing a mortgage are a 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, you exchange 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.
The Basics of Mortgage Refinancing
Think of refinancing as replacing an existing mortgage with another or consolidating a pair of mortgages into a single loan. Out with the old (mortgage) and in with the new. After the refinance, the old loan(s) is paid off, and a new one replaces it.
There are plenty of reasons to consider refinancing. Saving money is the obvious one. In August 2008, the average 30-year fixed-rate 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%. It peaked in 2018 at 4.54%, then slid to 3.94% for 2019, and then fell further with an annual average of 3.11%, in 2020, according to Freddie Mac.
For most people, avoiding the added cost of a cash-out loan and taking a rate-and-term loan is the best financial move. However, if you have a specific reason for taking cash out of your home, then a cash-out loan may be valuable. Remember, though, that the extra money you'll pay in interest over the life of the loan can make it a bad idea.
According to Mike Fratantoni, the Mortgage Banker Association (MBA) senior vice president and chief economist, the cause was “increasing concerns regarding the economic impact from the spread of the coronavirus, as well as the tremendous financial market volatility."
Fratantoni added that "given the further drop in Treasury rates this week, we expect refinance activity will increase even more until fears subside and rates stabilize.” These low rates are an important reason for homeowners with older, higher-interest mortgages, those whose home equity has risen, and those who have much better credit ratings than when they originally financed their home to look at refinancing now. By December 2020, they had dropped even further, to 2.68%.
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's often challenging to forecast the future direction of interest rates, even for the most seasoned economists.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
Cash-out vs. Rate-and-Term Refi
The simplest and most straightforward option is rate-and-term refinance. No actual money changes hands in this case, except for the fees associated with the loan. The mortgage's size remains the same; you trade your current mortgage terms for newer (presumably better) terms.
In contrast, in a cash-out refinance loan, 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 property's appraised value). In other words, it’s easier to get the loan 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 certificate of deposit (CD) that earns 1.58% or even 2.5% when your mortgage interest is 3.9%.
Cash-out Loans Are Pricier
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—just how much depends on the amount of equity you have built up in your home along with your credit score.
For example, if your FICO score is 700, your loan-to-value ratio is 76%, and the loan is considered cash-out, the lender might add 0.750 basis points to the up-front cost of the loan. If the loan amount is $200,000, the lender would add $1,500 to the cost (though every lender is different). Alternatively, you could pay a higher interest rate—0.125% to 0.250% more, depending on market conditions.
One more reason to think twice about cash-outs: Doing a cash-out refinance can negatively affect your FICO score.
Special Considerations on Cash-Out Loans
In certain circumstances, however, cash-out loans may not have tougher terms. A higher credit score and lower loan-to-value ratio can shift the numbers substantially in your favor. If you have a credit score of 750 and a loan-to-value ratio of less than 60%, for example, you won’t be charged any additional cost for a cash-out loan. That’s because the lender would believe that you are 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.
Americans Split on Cash-out Refinance
Although many personal finance experts would advise against stripping your home of its equity in a cash-out refinance, data shows that nearly half of Americans choose this loan type.
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. If you consider this option, it may be wise to consult with a mortgage expert because it is a complicated process that will affect any escrow accounts.
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.