If you’re thinking about doing a cash out refi, you probably already know that rates are often higher for this type of refinance.
First, what is a cash out refi? The simple answer is: A cash out refi is a refinance where you walk away with cash. Fannie Mae defines a cash out refinance as any refinance where cash back to the borrower exceeds the lesser of 2% of the new loan amount or $2,000. However, Fannie Mae also calls certain refinances “cash out refi’s” even if you don’t walk away with a dime. Why does it matter whether a loan is considered a cash out refi or not?
Because cash out refi’s often have higher interest rates and tougher underwriting guidelines than rate and term refinances. Does that mean you have to pay a higher rate? Not necessarily. This article will show you five ways to save money when you’re doing a cash out refi.
First, let’s go through an example of a cash out refi. You owe $300,000 on the mortgage on your home. You want to pull some cash out of your home for home improvement. You apply for a new loan amount of $400,000. At closing, the $400,000 loan is used to pay off the existing loan of $300,000 and you walk away from the closing with $100,000 in cash. Since the cash back exceeds the lesser of 2% of your loan amount or $2,000, this loan is considered a cash out refinance.
Here’s another example: you have a first mortgage for $300,000, and a second mortgage for $100,000. You got the second mortgage after you bought your house. You apply for a new loan of $400,000 to pay off the first and second mortgage, which add up to $400,000. Your new loan amount is the same as the mortgages you’re paying off, so you don’t walk away with cash. Is this considered a cash out refi?
Based on Fannie Mae’s definition, you would probably say no. But Fannie Mae has an exception to the 2% or $2,000 rule, which says that if you pay off a second mortgage that was not used to purchase your home, it’s considered a cash out refi – even if you don’t walk away with cash!
What if you take out a loan that’s more than you owe right now, but the excess cash goes to someone else? Let’s say you’re getting divorced. You owe $250,000 on the mortgage on your home. Your divorce decree says you have to give your ex $100,000 to buy out their interest in the home. You apply for a mortgage of $350,000. At closing, you pay off the existing mortgage for $250,000. The excess $100,000 goes directly to your ex in the form of a check from the closing agent – you don’t get that cash. Fannie Mae does not call this a cash out refinance, because the loan proceeds are being used to buy out another person’s interest in the property and the amount went directly to that person, not to you.
Sound confusing? It can be, but it makes sense once you understand the lender’s perception of risk. With the divorce situation, you are not taking equity out of your home — you are paying off your ex so you can go from a shared equity position to one where you own the house 100%. From the lender’s standpoint, this refinance does not represent a credit risk. Compare that to a loan where you own your house free and clear (with no mortgage on it) and you apply for a loan of $300,000. You are substantially reducing the amount of equity in your home. A cash out refi like this one is viewed as riskier by lenders, and that perception of risk affects your interest rate, loan-to-value, and the approval process.
Why are cash out refi’s viewed as riskier?
Cash out refi’s are considered riskier than rate and term refinances because with the latter, you are paying off the existing mortgage on your home in order to reduce the interest rate on the loan or reduce the term. From a lender’s standpoint, either of these reasons represents a good credit risk. You are lowering your monthly payments or building equity. However, with a cash out refinance, you are increasing your loan amount, which increases your monthly payment and reduces your equity. Lenders view these two events as representing a bigger credit risk.
How does this increased risk affect you?
INCREASED RISK AFFECTS YOUR LOAN 3 WAYS:
- Loan to value
Cash out refinances have pricing adjustments which means with most conventional loan programs, you will pay a higher interest rate if the loan is considered a cash out refi. How much higher? It depends on these factors:
5 FACTORS THAT AFFECT YOUR INTEREST RATE:
- Loan to value
- Credit score
- Property type
- Loan amount
- Debt-to-Income Ratios
Interest Rates Can Be Higher For Cash Out Refi’s
If you have a very low loan-to-value and a high credit score, your rate for a cash out refi may be very similar to the rate for a rate and term refi. But if you have a high loan-to-value and a lower credit score, your rate could be significantly higher than it would be for a rate and term refi.
Underwriting Guidelines Are Stricter For Cash Out Refi’s
Underwriting guidelines are also more strict for a cash out refi. You may need to have more income to qualify or a higher credit score. You may also need to show reserves or assets after you close that you can rely on to pay your mortgage in case you lose your job or you run into an unexpected home repair.
Loan-to-Values Can Be Lower For Cash Out Refi’s
The loan-to-value for a cash out refi is usually lower than for a rate and term refinance. You can typically borrow up to 90% of your home’s value with a rate and term refinance. Cash out refi’s are usually capped at 80% loan-to-value.
How do you get the best rate on a cash out refi?
By doing these 5 things:
- Ask your loan officer if paying down debt would improve your credit score. If you can move from a 680 score to a 720 score, you could get a better rate.
- Ask your loan officer if adding a co-signor would lower your debt-to-income ratios. If you lower your ratio from 49% to 42%, you could get a better rate.
- Ask your loan officer if you can break your loan up into two parts with a first and second mortgage (like a HELOC) to lower your loan-to-value. This option could work if you don’t need all the loan proceeds right away. This way, you have a lower loan-to-value which could help you get a better rate, but you still have access to more money through the HELOC.
- Ask your loan officer if lowering your loan amount would make a difference in your rate. If you keep your loan within the FNMA limits, you could get a better rate.
- And lastly, ask your loan officer if there are any programs where the rates are the same for rate and term and cash out refinances. The experienced loan officers at Amerifund can help you find the right loan at the best rate.
(c) Eris Saari 2019