Definition of a Cash Out Refinance
You want to renovate your home. You sit down with your lender and he says “you need to do a cash out refinance.” Why? How does that work? And what are your options?
Let’s say you own your own home. You owe $300,000 on your mortgage. Your house is worth approximately $500,000. It needs a new kitchen and you’d like to build an addition for more living space. The whole project will cost around $75,000.
Rates are low, so you think about borrowing money against the equity in your home. You ask about doing a home equity line, but your lender tells you you can save money by doing a cash out refi instead. You would apply for a new loan of $375,000; pay off the existing mortgage of $300,000; and walk away with $75,000 in cash.
Your loan would be considered a cash out refinance because you are walking away from the closing with more than $2,000 or 2% of the loan amount. In your case, 2% of the loan amount is $7,500, so your loan fits the definition of a cash out refinance.
There’s another definition of a cash out refinance: if your new loan is paying off a second mortgage that was not used to purchase your house initially. Some borrowers take out two mortgages when they buy their home to avoid jumbo rates or PMI. You can pay off both mortgages and it would not be considered cash out. But if you got a second mortgage after you bought your house, paying it off would be considered a cash out refinance.
Pros and Cons of a Cash Out Refinance
Pros: borrow all the money at one rate
Cons: rates may be higher for a cash out refi
Borrow all the money at one rate
With a cash out refinance, you get a new loan for all the money you need at one rate. Compare this to the other way to take equity out of your home: through a second mortgage. Second mortgages can be fixed (often called a Home Equity Loan) or variable (Home Equity Line of Credit). These loans are usually at higher rates than first mortgages.
Rates may be higher for a cash out refi
With a cash out refi, you are taking equity out of your home. To a lender, that represents a credit risk compared to a rate and term refi. Rates are often higher when you are doing a cash out refi. How much higher? Sit down with your lender and go through the numbers. Compare the rate for a cash out refi to the rate if you just took a second mortgage.
What is a rate and term refinance?
A rate and term refinance uses the definition above: it’s a rate and term refi if you don’t walk away from the closing with the lesser of $2,000 or 2% of your loan amount.
Why are rate and term refinances seen as less risky?
Lenders perceive a rate and term refi as less risky because the borrower is refinancing for one of two reasons: to reduce the interest rate on their loan, or to reduce the term. Either reason means the borrow is saving money or building equity. These reasons represent a good credit risk for the lender.
Is the approval process the same for cash out refi’s?
Underwriting is more stringent for cash out refinances because of the perceived risk. You might have to have a higher credit score or be limited in how much you can borrow. A rate and term refinance for example can often go up to 90% of your home’s value. Most cash out refinances are limited to 80% or less.
Which is better — a cash out refi or an equity line of credit?
In the example above, you needed $75,000 to do your home renovation. How do you decide if you should do a cash out refinance or just take an equity line of credit?
Here are three things you should consider:
- what is the rate and closing costs for a cash out refi
- what is the rate and closing costs for the equity line of credit
- do you anticipate being able to pay off the renovation costs
Ask your lender what the rate would be for a cash out refinance on the $375,000 loan. Then compare it to the rate and payments for an equity line of credit. These HELOCs are usually based on Prime so they can go up if Prime goes up. However, payments are usually based just on what you owe at any point in time. So if you think you could pay down or off the equity line, it might be a cheaper way to go.
Cash Out Refinance for Divorce Reasons
There is one exception to the 2% or $2,000 rule. Let’s say you need the $75,000 not for home renovation, but because you’re getting divorced. According to your divorce decree, your ex-partner will relinquish their rights of ownership to your home once they get paid off $75,000.
Important Tip: Lenders do not call this a cash out refinance! If the money from the refinance is going to another party, they don’t consider this type of refinance a cash out. So you can get the same low rates as you would with a rate and term refinance.
If you’re doing a cash out refinance and would like to talk to one of the experienced loan officers at Amerifund, call (888) 650-7316. Or fill out this form and someone will contact you.
Bottom line, you don’t always have to pay more when you’re doing a cash out refinance.
(c) Copyright Eris Saari 2019