Cash-Out Refinance vs. Rate and Term Refinance

November 18, 2011 No Comments »
Cash-Out Refinance vs. Rate and Term Refinance

Mortgage match-ups: “Cash-out refinance vs. rate and term refinance.”

It’s time for another installment of mortgage match-up, though this installment is more about distinction than rivalry.

If you’re in the market to refinance your existing mortgage, you’ll most likely be asked if you want any “cash out” with that.

This is similar to how you’re asked if you “want fries with that” at the drive-thru window when ordering a burger. Okay, maybe not that similar, but you get my point. It’s an option or an add-on.

Typically, if you fill out a mortgage application online or request a rate quote, one of the questions will be “cash out?” And if you answer yes, they’ll ask how much cash out.

Additionally, loan officers and mortgage brokers will ask this question to determine what type of refinance you want/need.

And it’s important because the pricing and qualification will differ depending on which type you choose.

Rate and Term Refinance

Let’s start with the most basic mortgage refinance, which is the rate and term refinance. If you don’t want any cash out, you’ll simply be looking to lower your interest rate and possibly adjust the term of your existing mortgage.

So if you currently have a 30-year fixed-rate mortgage at an interest rate of 6.5%, you may be inquiring about lowering your rate and potentially reducing your term as well.

Example:

Loan amount: $200,000
Existing mortgage rate: 6.5% 30-year fixed
Existing mortgage payment: $1,264.14
New mortgage rate: 3.25% 15-year fixed
New mortgage payment: $1,405.34

In this scenario, you’ll notice that your loan amount remains unchanged because it’s merely a rate and term refinance, but your interest rate drops and your mortgage term is also reduced from 30 years to 15 years.

At the same time, your monthly mortgage payment increases nearly $150. While this may seem like bad news, it’ll mean much less will be paid in interest over the shorter term and the mortgage will be paid off much quicker. We’re talking half the time.

For those who don’t want a mortgage hanging over their head for 30 years, this use of a rate and term refinance can be a good strategy. Especially since the big difference in rate barely increases the monthly payment.

But you don’t need to reduce your term to take advantage of a rate and term refinance. You can simply refinance from one 30-year fixed into another 30-year fixed, or from an adjustable-rate mortgage into a fixed mortgage to avoid a rate reset.

So there are plenty of options here – just be sure that you’re actually saving money by refinancing, as the closing costs can eclipse the savings if you’re not careful.

If you’re keeping your term the same, the refinance will serve to lower monthly payments, which is also a common reason to refinance a mortgage. Simply to pay less each month if you’re short on funds, or to put your money to work elsewhere, such as in another investment.

[When is the best time to refinance a mortgage?]

Cash Out Refinance

For homeowners who do want cash out, which is only an option for those with home equity (not as many homeowners as it used to be), your mortgage balance will grow as a result of the refinance.

In short, your new loan amount will be the sum of your existing mortgage amount plus any cash out you elect to receive.

While this means more money in your pocket, it also means a larger mortgage balance and possibly a higher monthly payment, depending on the difference between the old rate and the new rate.

Example:

Loan amount: $200,000
Existing mortgage rate: 6.5% 30-year fixed
Existing mortgage payment: $1,264.14
Cash out amount: $50,000
New loan amount: $250,000
New mortgage rate: 4.25% 30-year fixed
New mortgage payment: $ 1,229.85

In this scenario, you’d refinance from a 30-year fixed into another 30-year fixed, but you’d lower your mortgage rate significantly and get $50,000 cash in your pocket (less closing costs).

At the same time, your monthly mortgage payment would actually fall $35 because your former interest rate was so high relative to current mortgage rates.

While this all sounds like good news, you’ll be stuck with a larger mortgage balance and a fresh 30-year term on your mortgage.

So if you’re looking to pay off your mortgage in full some day soon, this isn’t the best move. But if you need cash for something, whether it’s for an investment or to pay off other more expensive debts, this could be a worthwhile decision.

Just note that cash-out refinances typically come with additional pricing adjustments that increase the interest rate you will ultimately receive. This means instead of receiving a 4% mortgage rate, you may be stuck with a rate of 4.25% or higher depending on the loan scenario.

Additionally, qualifying for a cash-out refinance will be more difficult because the larger loan amount will raise your loan-to-value ratio and put increased pressure on your debt-to-income ratio.

In summary, be sure to do the math and plenty of shopping around to determine which type of refinance is best for you.

Read more: 7 reasons why you can’t refinance your mortgage.

(photo: eckes/bernd)


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