When refinancing, if a borrower chooses to take cash-out in addition to their existing mortgage balance, the new mortgage balance will consist of the current balance plus the desired cash-out amount. This type of refinance is referred to as a “cash-out refinance” (how does refinancing work?). It will increase both the size of your mortgage and your mortgage payment in return for cold, hard cash.
There are two ways a borrower can tap into home equity. They can either open up a home equity line of credit, also known as a Heloc, behind their existing first mortgage, or refinance their existing mortgage into one or two loans.
Let’s look at an example where a homeowner wishes to get $100,000 cash-out of their home:
Home value: $500,000
Existing liens: $300,000 (fancy way of saying current loan balance)
Equity: $200,000
In the above example, the homeowner has an existing mortgage of $300,000. The home is worth $500,000, so the homeowner has $200,000 worth of equity. In other words, the homeowner essentially owns $200,000 worth of their home, or 40% of the current property value. As mentioned, if the homeowner wishes to tap into that equity, they can get a second mortgage or execute a cash-out refinance.
Let’s assume the homeowner opted to add a second mortgage:
Home value: $500,000
Existing liens: $400,000 ($300,000 1st mortgage, $100,000 2nd Heloc)
Equity: $100,000
In the above example, the homeowner added a second mortgage behind their existing $300,000 first mortgage. The $100,000 home equity line they added increases their existing liens amount to $400,000, and subsequently lowers the equity in their home to $100,000. But the homeowner now has a $100,000 credit line to use for whatever they wish, without changing the rate or terms of the existing mortgage.
Now let’s look at the same example, assuming they executed a cash-out refinance by refinancing their existing loan and adding cash-out in a single loan:
Home value: $500,000
Existing liens: $400,000 ($400,000 1st mortgage, no 2nd mortgage)
Equity: $100,000
In this example, the homeowner refinanced their original $300,000 mortgage and added $100,000 cash-out in addition to it, creating a new $400,000 mortgage. The amount of equity and cash-out are the same in this example. The only difference is that the homeowner still has a single loan, although a completely new mortgage with a new rate and set of terms, quite possibly with a different bank or mortgage lender.
So which approach works best? When looking to execute a cash-out refinance, it’s important to decide which method makes sense for your unique financial situation. If interest rates are low at the time you’re looking to cash-out, you may want to refinance your existing mortgage and consolidate the old mortgage and cash-out into a single loan as we saw in the second example.
If mortgage rates aren’t favorable but you still need cash-out, it’d probably be best to leave your first mortgage alone and add a second mortgage behind it that won’t affect the rate and terms of the first.
Things like remaining term must also be taken into account. If your mortgage is close to being paid off, it may be wise to leave it untouched and opt for pulling cash out via a second mortgage. If your mortgage is new and the rate is not all that favorable (or adjustable), it might make more sense to refinance the whole kit and caboodle.
So why do people elect to take cash out?
• Home improvements
• Future investments
• Vacations and other luxuries
• College tuition
• To purchase another property
• To consolidate and pay-off other higher-interest-rate debt, such as credit cards or auto loans
• For an emergency
Many homeowners use cash-out refinances for debt consolidation, home improvement, or for future investments. To avoid paying high-interest rate credit cards, homeowners may use cash out of their homes to pay off those bills. Instead of paying a 20% interest rate or higher on a credit card each month, you can pay off that balance using your mortgage and pay a rate of 5-8% instead.
Other homeowners may pull cash-out to make improvements to their home that will increase the value significantly, and lower their overall loan-to-value ratio and increase the equity in their home. Others will pull cash-out if they feel they can invest that money at a better rate of return than the actual interest rate.
The question you need to ask yourself is whether it makes sense financially to refinance your current mortgage to take advantage of the above list. Keep in mind that there are fees associated with a second mortgage, and even more if you plan on refinancing your current first mortgage and taking cash-out.
While a cash-out refinance can provide homeowners with much needed help in a dire situation, when you cash-out, you essentially reset your mortgage and lose all the equity you’ve spent years building. Not only do you lose your equity, but you also take on more debt.
A few important things to note about cash-out refinances:
Most lenders will not let homeowners take cash-out on their property without 12 months seasoning. Meaning that if you buy a property, you’ll need to sit on it for at least 12 months before taking any cash-out. Lenders enacted tougher cash-out rules to deter investors from buying homes with zero money down, and quickly refinancing them and taking cash out.
There are some lenders that will allow cash-out up to 75% loan-to-value without any property seasoning, but most homeowners who are looking for quick cash-out usually do not have 25% equity in their homes.
Another important note is that a refinance will be likely be considered cash-out if a borrower refinances a non-purchase money home equity line of credit. That is, if you open an equity line behind your existing first mortgage after the original purchase transaction and then later want to refinance it, it will be treated as a cash-out transaction even if you aren’t taking cash-out at that time. What this means to the homeowner is another pricing adjustment when they refinance, which will result in a higher interest rate. It’s not the end of the world, but something to consider.
Many borrowers also feel if they aren’t getting cash in their pocket, their refinance isn’t considered cash-out. This is false. If you pay off credit cards or auto loans and receive zero cash in hand, the bank or lender will still consider it cash-out, and it will be underwritten as such.
With any mortgage refinance, it is important to understand the costs involved and the underlying motivation. You should really avoid serially refinancing your loan if at all possible. Aside from the associated costs, you will set yourself back in paying off your mortgage, and end up paying more interest than if you simply left the mortgage alone. You could also land yourself in a negative equity position. That’s why a refinance should really only be reserved for times of great need, or in times when rates are simply too good to pass up.
