Cash Out Vs. Rate/Term Mortgage Refinancing Loans
Mortgage terminology got you down? Don't fret: Figuring out all of the complicated phrases and vocabulary like "amortization" and "loan to value" is enough to intimidate any borrower. And, if you're thinking of refinancing your mortgage, prepare to learn some new terms: "cash-out loan" and a "rate/term refinance." Let us introduce you.The Basics
First, think of refinancing as the replacement of an existing mortgage with another, or the consolidating a pair of mortgages into a single loan. (For more on the latter, See Should I Combine Two Mortgages Into One?) Out with the old (mortgage) and in with the new, as they say. Once you refinance, your old loan is paid off and a new one is put in its place.
There are plenty of reasons to consider refinancing. Saving money is the obvious one. In August 2008, the average 30-year fixed mortgage had an interest rate of 6.52%. After the financial crisis, rates for the same sort of mortgage were practically slashed in half. With a potential savings of, say, $500 per month on a $250,000 home, refinancing made sense for a lot of people. This resulted in a wave of refinances that still continues into 2015. Even a one-point difference in your rate could represent a $150 reduction in your payment. For more on this subject, see Should You Refinance Your Mortgage When Interest Rates Drop?
Refinancing can also offer a chance to convert your adjustable-rate mortgage into a fixed-rate one, in order to lock in lower-interest payments, especially if rates seem poised to move higher.Two Types of Loans
There are two basic refinance loans. The simplest and most straightforward is the rate/term refinance (refi). No actual money changes hands in this case, outside of the fees associated with the loan. The size of the mortgage remains the same; you simply trade your current mortgage terms for newer (presumably better) terms. In contrast, in a cash-out loan, aka cash-out refinance, the new mortgage is bigger than the old one. Along with new loan terms, you're also being advanced money – effectively taking equity out of your home, in the form of cash or to pay off other debts.
You can qualify for a rate/term refi with a higher loan-to-value ratio. (It's easier to get the loan, in other words, even if you're a poorer credit risk.) Cash-out loans come with tougher terms. If you want some of the equity you've built up in your home back in the form of cash, it's probably going to cost you – how much depends on how much equity you have built up in your home and your credit score.
For example, if a borrower's FICO score is 700, the loan-to-value ratio is 76% and the loan is considered cash-out, the lender might add 0.750 points to the up-front cost of the loan. (Each lender is different.) If the loan amount were $200,000, for example, the lender would add $1,500 to the cost. Alternatively, the borrower could pay a higher interest rate – 0.125% to 0.250% more, depending on market conditions.
Why the tougher terms? Because cash-out loans carry a higher risk to the lender, according to Casey Fleming, mortgage advisor, C2 Financial Corporation and author of The Loan Guide: How to Get the Best Possible Mortgage. Statistically a borrower is much more likely to walk away from a home if he gets in trouble if he has already pulled equity out of it. It is particularly true if he has pulled out more than he initially invested in the down payment. Consequently, any loan that is considered cash-out is priced higher to reflect that risk, until there is so much equity that the borrower isn't likely to walk away anymore.
But a higher credit score and lower loan-to-value ratio can shift the numbers substantially in your favor. For example, a borrower with a credit score of 750 and loan-to-value ratio of less than 60% won't pay any additional cost for a cash-out loan because he or she is no more likely to default on the loan than if he or she were doing a rate/term refi.
Your loan may be a cash-out loan even if you don't receive cash back. 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 cash-out.An Interesting Loophole
With the help of your mortgage broker, you may be to generate a little cash from your refinancing without it's 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. Here's how Fleming describes it:
You are allowed to finance closing costs in a rate/term refi. Most lenders allow those closing costs to include pre-paid expenses, such as pre-paid interest, the unpaid accrued interest on your existing mortgage, money necessary to pre-fund your escrow account and even property taxes and insurance if you time it right.
"When you refinance, you pay the accrued interest on your existing mortgage up to the day it is paid off. You pre-pay your interest on your new loan from the day you fund until the first of the next month, and then you don't make a payment the next month. Therefore, you have financed one month's interest on your mortgage within the new loan.
"If you have an impound (or escrow) account to pay insurance and taxes with your existing mortgage, then your existing lender is holding some of your money – at least a couple of months of taxes and insurance each. When you refinance, your new lender will need some money on hand when your tax and insurance bills come due, so they will ask for some money up front. You can usually finance this.
"Then, after your loan closes your old lender – who is holding some of your money – sends you a check equal to the balance of your escrow account when you paid off that loan. Cash!
"Also, because some of the fees change a little up until funding, most lenders allow a little bit of cushion – up to $2,000 in cash back in escrow without the loan being considered cash-out.
"What all this means is that you can finance 'costs' that aren't really the cost of originating the loan, but rather represent the cost of having the loan. On a $200,000 rate/term loan, it would be very feasible to generate about $4,000 in cash – the right circumstances, if it were structured carefully – without paying a cash-out penalty.The Bottom Line
Your job as the 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.