Cash-out refinancing is sort of the Swiss Army knife of the mortgage world. It performs multiple functions, including allowing home owners to accomplish the various goals of refinancing (lowering the interest rate, reducing monthly payments, switching between variable and fixed rates) while also making the equity-to-cash conversion of a home equity loan. The thing about multi-purpose tools, though, is that in some situation a more specialized device might do a better job. Multiple conditions have to line up to make the situation right for a cash-out refinance mortgage.
When is the right time to refinance with cash out? It depends on whether the right combination of uses for the loan, equity in the home, and the rates and terms of the loan line up. Here's what to look for:
Cash-out refinance can be a useful source of funding for needs such as:
- Home improvement. This is a natural, because it has a long-term benefit and reinvests in the property being mortgaged.
- Big-ticket purchases. This is a maybe. Cash-out refinancing might be the cheapest form of financing available for a major purchase like a car, but it also imposes harsher consequences for non-payment. Borrowers should pay particular attention to their ability to repay, especially in the event of a financial setback, because it is much more serious to have a home foreclosed on than a car repossessed.
- Education. Another maybe. Education can have long-term benefits, and a cash-out refinance loan may well be cheaper than a student loan. However, not only does a mortgage put the home on the line, but it also lacks the more forgiving payment terms of federal student loans, which may base repayment requirements on how much the borrower earns.
Less suitable uses include any form of short-term purchases and travel. It is generally a bad idea to use long-term borrowing to finance short-term consumption, and this is especially true when the collateral is the borrower's home.
The borrower's equity status - how much the current value of the home exceeds how much is owed on the mortgage - will determine the ability to get a cash-out refinance loan, and how good a deal it will be:
- Will there be enough equity left? In this case, the key is not really the equity with the current mortgage but the equity with the proposed refinanced mortgage. If the equity balance after refinancing with cash out would be too thin, this form of refinancing is probably not an option because cash-out refinancing typically requires a lower loan-to-value (LTV) ratio than ordinary refinancing.
- Exactly how large will that equity be? The home owner may have enough equity to take cash out and still meet lender LTV standards, but how much equity remains will make a difference in how good an interest rate is likely to be available. The lower the LTV ratio, the lower the interest rate is likely to be, and the difference could be enough to determine whether or not refinancing is cost-effective.
In short, a decent cushion of positive equity must be in place to refinance with cash out, and the bigger that cushion is, the more competitive the refinance mortgage rate is likely to be.
Rates and terms
If a borrower is simply refinancing the current mortgage balance, the decision largely comes down to a head-to-head comparison between the new loan and the existing loan. However because cash-out refinancing is part replacement for the existing loan and part home equity loan, it is necessary to compare the proposed new loan with both the existing loan and a home equity alternative.
- Comparison with the current loan. Generally speaking, a cash-out refinance loan only makes sense if the new interest rate is cheaper than the rate on the existing loan. Otherwise, why raise the interest rate on the entire loan balance just to access home equity? If the two interest rates are close, it may come down to a comparison with a home equity loan rate.
- Comparison with a home equity loan rate. Because home equity loans are second mortgages, their rates tend to be higher than those of primary mortgages, including cash-out refinance loans. So, even if the rate comparison with the existing mortgage is more or less even after loan costs, the borrower might still come out ahead with cash-out refinancing if there is a significant savings over the home equity loan rate. The bigger the proportion of equity being accessed relative to the existing loan balance, the greater the chance that the advantage of the cash-out refinance rate over the home equity rate could swing the comparison.
Other factors to consider with regards to rates and terms include whether refinancing is an opportunity to switch from an adjustable to a fixed rate of interest, or whether the goal is to lower monthly payments by spreading the loan over a longer period of time. Both could be accomplished with a cash-out loan (though chances are the latter would only work if the original loan was several years old), but in either case the home owner should consider whether it is better to accomplish these things and access home equity all in one move, or whether they would be better achieved with two separate loans.
Again, the Swiss Army knife-like versatility of cash-out refinancing can help home owners accomplish multiple things when they refinance, but it also means they need to account for multiple conditions in assessing whether it is the right tool for the job at hand.