There are two main types of mortgage refinances. There is the standard rate and term refinance, which allows a borrower to snag a lower mortgage rate or shorten their term, while keeping their existing balance intact. And then there is the “cash-out refinance,” which allows a borrower to tap into the equity in their home.
When refinancing, if a borrower elects to take “cash out” in addition to their existing loan, the new mortgage balance will be larger than the original. That’s right, it’s not free money!
Once the refinance is complete, the new loan will consist of the current balance plus the desired cash-out amount. So expect both the size of your mortgage and your mortgage payment to increase in return for cold, hard cash.
There are two ways a borrower can tap into their 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(s) and take cash out.
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)
Home equity: $200,000
In the above example, the homeowner has an existing mortgage balance of $300,000. The home is currently worth $500,000, so the homeowner has $200,000 in home equity. In other words, the homeowner essentially owns $200,000 of their home, or 40% of the current property value. As mentioned, if the homeowner wishes to tap into that equity, they can either get a second mortgage (HELOC) or execute a cash-out refinance.
Let’s assume the homeowner opts to add a second mortgage:
Home value: $500,000
Existing liens: $400,000 ($300,000 1st mortgage, $100,000 HELOC)
Home 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 balance 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 term of the existing first mortgage. This is NOT a cash-out refinance.
Now let’s assume they execute a cash-out refinance by refinancing their existing loan and adding cash-out:
Home value: $500,000
Existing liens: $400,000 ($400,000 1st mortgage, no 2nd mortgage)
Home equity: $100,000
In this example, the homeowner refinanced their original $300,000 mortgage and took $100,000 cash out, 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 fresh rate and term, 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 last 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 way it won’t affect the rate and term of the first mortgage.
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. But if your mortgage is new and the interest 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 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 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. Just realize the risk involved if you fail to make your mortgage payments.
Other homeowners may pull cash-out to make improvements to their home that will increase the value significantly, which over time can lower their loan-to-value ratio and increase the equity in their home. Others may pull cash-out if they feel they can invest the money at a better rate of return than the mortgage 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 taking out a second mortgage, and even more if you plan on refinancing your 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 a year 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 may mean 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 avoid serially refinancing your mortgage if at all possible. Aside from the associated costs, you will set yourself back in paying off your mortgage, and wind 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.