Cash Out Refi (Refinancing)
It almost sounds too good to be true. But it is true. If it’s somethingyou’d like to consider, what follows is everything you need to know to help you decide whether cash out refinancing, or cash-out refi as it’s more commonly known, it is the best choice for your situation.
Cash out refi (refinancing) involves using the equity in your home as a source of cash. You start by determining the balance on your existing mortgage and add to that the amount of cash you require. The total is the amount you would refinance.
If, for example, you currently owe $75,000 on your home and need $25,000 to add a second floor, you would refinance $100,000 at a (hopefully) lower interest rate. At closing, you would get a check for $25,000 for the home improvement (or whatever you wish to spend that money on). You would also end up with lower monthly mortgage payments because of the better interest rate you secured during the cash out refi process.
Understand the different refi options
What’s most important to realize is that cash-out refinancing is different than a home equity loan (second mortgage), a home equity line of credit, and a reverse mortgage. Interestingly however, many homeowners do not fully understand the differences. All involve your home, but that is pretty much where the similarities end.
As mentioned previously, cash-out refinancing can give you two things: a lower interest rate and cash. Unlike a home equity loan (which acts as a second mortgage on your home), cash-out loan products replace your existing mortgage. You use the funds borrowed through the cash-out refi process to pay off your existing loan. Then you make payments on the refinanced amount.
Because it is less risky, chances are you will be quoted a better interest rate on a cash-out refi than you would be offered if applying for a home equity loan. You will have to apply for a cash-out refi. And you will have to pay closing costs that can range from several hundred to several thousand dollars; something that is usually not required when applying for a second mortgage.
Although it does sound enticing, cash out refinancing does not always make sense. If you already have a low interest rate on your existing mortgage, you may not be quoted anything lower. Refinancing at a higher interest rate definitely does not make sense, no matter how much money you can get. In this case, you would probably be better off applying for a home equity loan.
If you are at the point where more of your monthly mortgage payment is going towards principle than to interest, usually around the 20-year mark of a 30-year mortgage, this is another situation where cash-out refinancing, even into a slightly lower interest rate, may not be more advantageous.
What really counts in a cash out refi
The decision ultimately comes down to what you’d be using the money for and how much savings you would realize each month. Money from a cash-out refi should not be used to pay the cost of a wedding, vacation, new car or other type of spending spree. It’s also not the best choice if you are trying to eliminate debt. Remember you will be repaying this type of mortgage for another 15 to 30 years. If you can eliminate your debt or pay for your purchase sooner, do not opt for a cash-out refi. Find another funding source.
It is better to use the money from a cash-out refi for projects that will actually add value to your home. Another good use of the cash is to cover experimental medical treatments that your insurance won’t cover or to start your own business.
Something else to consider is the cost of a cash-out refi. If the amount you plan to borrow exceeds 80% of your home’s appraised value, your lender will require you to pay PMI or Private Mortgage Interest. This can add quite a bit onto your monthly payment, up to several hundred dollars. And you will be required to continue paying PMI until the amount owed is less than 80% of the home’s value.
In summary, think long and hard before you use your home as your personal piggy bank. Ask questions, compare loan products and associated costs, consider how you’ll use the cash, and most importantly, consider the consequences of defaulting on your cash out refi. Only then should you make your decision.