How Cash-Out Refinancing Works
What is cash-out refinancing?
A refinance in which the new loan amount exceeds the total needed to pay off the existing mortgage. The difference goes to the borrower and can be used for any purpose.
- Cash-Out Refinancing
- A refinance in which the new loan amount exceeds the total needed to pay off the existing mortgage. The difference goes to the borrower and can be... <a href='/glossary/what-is-cash-out-refinancing' title='See the full definition of Cash-Out Refinancing '>read more</a>
- The difference between the fair market value of an asset (like a home) and the amount of debt against that asset (like a mortgage balance). <a href='/glossary/what-is-equity' title='See the full definition of Equity'>read more</a>
- Rate and Term Refinancing
- A mortgage refinance that replaces the existing mortgage with a new one but does not disburse cash to the borrower. Rate and term refinancing is... <a href='/glossary/what-is-rate-and-term-refinancing' title='See the full definition of Rate and Term Refinancing'>read more</a>
- Refinancing means replacing one loan with a new, better loan. Improving the terms of a loan can mean obtaining a lower interest rate, a lower monthly... <a href='/glossary/what-is-refinancing' title='See the full definition of Refinance'>read more</a>
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 a cash-out refinance if the new loan comes with a better refinance 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 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. 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.
|Loan-to-Value (LTV) based on credit score|
Cash-Out Refinance Pros
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.
Cash-Out Refinance Cons
- 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.
Frequently Asked Questions
My wife and I are looking to refinance our 1st and 2nd mortgage and are at wits end.
4 Answers | asked 1 year ago
What's the minimum credit score needed to refinance?
5 Answers | asked 1 year ago
Concerned about Refi on Internet
2 Answers | asked 8 months ago
How many loans have you processed as a loan officer.
3 Answers | asked 11 months ago
4 Answers | asked 1 year ago