Cash-out Refinance: 3 Ways to Get it Really Wrong

The foreclosure crisis in 2008 was preceded by an enormous boom in cash-out mortgage refinancing – more than 80 percent of borrowers increased the size of their home loans when they refinanced, depleting their equity and helping bring on the most serious recession in US history. By 2012, cash-out mortgages had dropped to less than ten percent of refinance transactions.

Cash-out Refinance: It's Still a Thing

Today, as property values recover, cash-out refinancing is increasing – by the end of 2014, nearly 30 percent of refinances involved some cash out. You might be tempted to join those homeowners, especially if the Great Recession was hard on you financially. Keep in mind that there is a right way and a wrong way to pull off a cash-out refinance. Avoid these three mistakes and you'll be good to go.

Fail! Not Considering Alternatives

Cash-out refinancing today is very different from cash-out refinancing in 2008. The National Bureau of Economic Research and others have laid a large portion of the blame for the foreclosure crisis on the cash-out refinancing boom immediately preceding it. Lenders today seem to be doing everything they can to discourage cash-out refinancing. The underwriting guidelines are more stringent. The maximum loan-to-values have dropped. And most importantly, the costs have been ratcheted up. For example, if your credit score is 659 or lower and you want a cash-out refi from Fannie Mae, you're going to pay three points for the privilege.

That's three percent of the entire loan amount. This means if you refinance a $200,000 mortgage and add $25,000 in cash back, the three percent surcharge is $6,750 – and comes to 27 percent of the cash out! Unless your credit score is perfect, the amount of cash you want is huge and your loan-to-value is 75 percent or less, cash-out refinancing is likely to be more expensive than several other options. You could refinance the mortgage without cash out and add a home equity loan. You could leave the first mortgage alone and add a home equity loan. You could take out a personal loan. Depending on the circumstances, even a credit card might be cheapest. The cash-out refinance might still be the lowest cost choice, but you won't know unless you explore other opportunities.

Fail! Getting Hit with MI

Conventional (non-government) lenders may allow cash-out refinances of up to 85 percent of the property value, but they will require mortgage insurance if your refinance exceeds an 80 percent loan-to-value. You could be hit with cash-out refinancing surcharges from your lender and have to pay for mortgage insurance as well. Again, if you're considering cashing out, look into other options – and that goes double if your cash-out refinance involves mortgage insurance premiums.

What about cash out refinancing with a government loan? That's an option, and it might make sense because there is no increase in fees for taking cash out, and no extra mortgage insurance. FHA allows cash-out refinances to 85 percent of the property value, with no extra fees, and FHA mortgage rates are often lower than conventional mortgage rates. That's the good news. The bad news is that FHA charges mortgage insurance for every loan regardless of the loan-to-value or the existence of cash out. However, a cash-out refinance with FHA, especially to 85 percent of the property value and for a borrower with less-than awesome credit, could be less expensive than a conventional (non-government) refinance. Homeowners who can qualify for a VA cash-out refinance can borrow against 100 percent of the property value without paying mortgage insurance premiums.

Fail! Using a Sledge Hammer to Kill a Mosquito

This mistake concerns the use of money from cash-out refinancing. In general, it's not the best idea to finance a short-term need with a long-term loan. If you want to borrow money to take a fantastic vacation, for example, cash-out refinancing might look like a better choice than a personal loan. Mortgage rates, after all, are under four percent at the time of this writing, while most personal loans or credit card rates are at least twice that. And mortgage borrowing can be tax-deductible, which can make it even cheaper (check with a tax pro).

However, there are other considerations. First, there are the fees for cash-out refinancing. But the other factor is the time to repay the loan. If you borrow for a two-week vacation and wrap it into a 30-year mortgage, the costs can far outstrip what you'd pay for the same amount with a personal loan, even at a higher interest rate. While $5,000 wrapped into a 4.0 percent mortgage might cost $23.87 per month, in 30 years the cost comes to $8,593.48. At ten percent, a 5-year personal loan costs $106.24 per month, but the debt is repaid in five years and the total cost is over $2,200 less. In general, most financial advisors don't recommend very long-term financing to cover short-term needs (or on this case, a short-term want).

In other words, beating a tiny debt to death with a huge loan.

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