Cash Out Refinance vs. Rate and Term Refinance

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

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

If you’re in the market to refinance your current mortgage rate, 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.

Loan officers and mortgage brokers 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

If you don’t want any cash out, you’ll simply be looking to lower your interest rate and possibly alter the term of your current mortgage.

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

Example:

Loan amount: $200,000
Current mortgage rate: 6.5% 30-year fixed
Current 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, but your interest rate drops and your mortgage term is 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.

For those that don’t want a mortgage hanging over their head, this use of a rate and term refinance can be a good strategy.

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.

Cash Out Refinance

For those 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 mortgage amount will be the combination 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.

Example:

Loan amount: $200,000
Current mortgage rate: 6.5% 30-year fixed
Current 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 and get $50,000 cash out.

At the same time, your monthly mortgage payment would actually fall $35 because your former interest rate was so high relative to today’s 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, this isn’t the move. But if you need cash for something, whether it’s for an investment or to pay off other debts, this could be a worthwhile decision.

Just note that cash-out refinances typically come with pricing adjustments that raise the interest rate. So instead of receiving a 4% mortgage rate, you may be stuck with a 4.25% rate or higher.

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 pressure on your debt-to-income ratio.

In closing, 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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