There’s more than one way to convert equity to cash
The cash out refinance is designed to accomplish two goals -- to improve on the terms of an existing home loan and deliver additional funds at a low interest rate. Other types of mortgage refinance include the rate and term refinance, in which the new loan amount is equal to the remaining balance on the old mortgage, and the limited cash out refinance, in which the closing costs are added wrapped into the new loan, increasing its balance.
It only makes sense to undertake refinance with cash out if the new loan comes with a better interest rate or more favorable terms (replacing an adjustable rate home loan with a fixed rate mortgage, for example).
Refinance with Cash Out: Conforming Loans
It is important to note that cash out refinancing generally costs more than rate and term or limited cash out refinancing. Fannie Mae and Freddie Mac, for example, require lenders to collect surcharges for these loans (called "conforming" mortgages) because they are considered riskier. The chart below shows the added costs, which depend on the borrower's credit score and the loan-to-value ratio. Notice cash out is limited to 85 percent of the property value.
The added costs of cash out refinancing can be substantial and should be considered carefully. If, for example, a homeowner wishes to refinance a $200,000 mortgage and take an additional $10,000 cash out, there may be no extra costs (the new loan amount is less than 60 percent of the home's value and the borrower has a 700 FICO score, for example). On the other hand, if the homeowner has a 650 FICO and the new loan amount is 83 percent of the property value, it would cost an extra $6,300 to borrow $10,000!
In general, cash out refinancing is likely to be the lowest cost option when the amount of additional cash is relatively high. In the above example, the added costs come to 63 percent of the amount borrowed. If the homeowner were to take $100,000 cash out, however, the added costs come to nine percent of the amount borrowed -- a considerably lower figure.
FHA, VA and USDA
FHA mortgages can also be refinanced to 85 percent of the property value with cash out. Unlike conforming cash out refinances, FHA loans do not require additional risk-based surcharges. However, FHA mortgages do require hefty mortgage insurance premiums. Homeowners with high loan-to-value ratios and low credit scores should compare both options -- they might be better off with the FHA product.
Homeowners who are eligible for a VA cash out refinance can refinance up to 100 percent of their home's value and pay no mortgage insurance premiums. However, while the funding fee for a rate and term or limited cash out refinance is .5 percent, the fee for a cash out refinance ranges from 2.15 to 3.3 percent, comparable to the fees assessed for conforming mortgages.
Homeowners who wish to refinance (cash out) with the USDA Rural Housing program are out of luck -- cash out refinancing is not allowed under this program.
Cash out refinancing offers a few advantages over other sources of funds:
- Because it's secured by real estate, the interest rate is lower than rates for unsecured financing.
- Because it's a first mortgage, the interest rate is lower than rates for home equity loans, which are usually second mortgages.
- The interest may be tax-deductible. Check with a tax pro.
- Underwriting guidelines are stricter than for rate and term refinancing.
- Costs are higher because surcharges are assessed against the entire refinance, not just the amount of cash out.
- Cash out refinancing takes longer than setting up a home equity loan or personal (unsecured) loan.
- Increasing the loan-to-value to over 80 percent requires mortgage insurance.
Alternatives to Cash Out Refinancing
Homeowners considering a cash out refinance should compare the costs of all available options:
- Rate and term refinance plus a home equity loan (if terms of existing loan can be bettered)
- Adding just a home equity loan (if existing loan cannot be improved)
- Taking a personal loan (if credit rating is good and costs are low)
- Consolidating debt with a debt management plan or balance transfer card
Cash out refinancing is a valid strategy for financing anything from college tuition to debt consolidation to home improvements. However, homeowners should run the numbers and consider the total cost of borrowing -- lender fees, interest rates and third party costs -- before committing.