Most people tend to refinance their mortgages when interest rates fall, with the potential monthly savings to the average homeowner serving as an enticement and temptation to play ‘let’s make a deal’ with lenders.
In fact, an estimated 9.4 million borrowers were recently projected to save an average of $272 per month with a typical mortgage refinance, according to data compiled by analytics company Black Knight.
The difference is knowing that these calculations have been made for straight home refinancing, and there are plenty of homeowners looking at alternatives — including cash-out refinancing. It all comes down to those who have sizeable equity in their homes and could potentially use lower rates to take cash out.
Of course, there are rules when it comes to tapping that home equity and a need to understand just how cash-out refinance rates work.
Cash-Out Refinance – What It Is and What It’s Not
A cash-out refinance is not like a home equity line of credit (HELOC) or a home equity loan. Instead, a cash-out refinance replaces your existing mortgage with a brand new loan — for more than you previously owed.
According to Zillow, the ‘cash-out’ portion of the deal takes place when you agree to pay more than your original mortgage amount to liquidate some of the equity in your home. In other words, you use the equity you have in the property to obtain cash, with the deal adding to the principal of your mortgage.
Let’s say that you own a home currently worth $250,000 and owe $170,000 on your mortgage. You decide to apply for a cash-out refinance and ask your lender for $40,000. Your new mortgage principal would be for $210,000, and you get the difference between the old principal and the new principal in cash after closing.
Why Cash-Out Refinance Is Attractive to Homeowners
Millions of borrowers are always looking to save big on a mortgage refinance, and a large amount of equity in a home can make the deal even more attractive. In fact, CNBC said homeowners had a collective $6 trillion in home equity as of January 2020.
The CNBC report said borrowers have also been conservative about tapping into the equity in their homes, in large part due to the housing crash that defined and reshaped the last decade. The business news channel reported that just $54 billion in equity was withdrawn in the first quarter of last year, the lowest volume in quite some time.
According to Credit Karma, some people use the money from a cash-out refinance to invest in home improvements. However, others use it to consolidate high-interest debt such as personal loans, auto loans, and credit card loans.
How Cash-Out Refinance Rates Really Work
Remember how most people tend to refinance when interest rates fall because they’re looking to save money? A cash-out refinance typically carries a higher interest rate than a straight home refinance for a number of reasons:
– When you structure a cash-out refinance, your lender is assuming more risk because your new loan is more than what you previously owed. It’s hard to quantify what a change in your rate might look like vs. a friend or neighbor, but a lender should be able to give you an idea when you shop for a loan.
– Risk-based mortgage pricing (or the underwriting of your new loan, according to Investopedia) is the practice in which the lender presents your new loan terms and conditions. For each applicant, it’s based on the lender’s assessment of their level of risk in extending a cash-out refinance to a borrower.
– Lenders will gauge the risk involved that any borrower might default or become delinquent on a loan, and a cash-out refinance doesn’t change that. Even if your original mortgage was paid on-time and in good standing, a lender will do their homework when it comes to assessing your current financial state.
Above all, you need to make the decision on whether you’re willing to pay a higher interest rate for the privilege of tapping the equity in your home. For some homeowners, the higher interest rate isn’t enough to stop them from refinancing, but for others, it can be a dealbreaker.
The 80% Rule on Cash-Out Refinance
It used to be that the limit on a cash-out refinance was set at 85% of a home’s value; before 2009 borrowers could even structure a cash-out refinance up to 95% of the value.
Lenders got wise to cash-out refinancing being used to fund luxury vacations or buy fancy cars. Now, the Federal Housing Administration (FHA) and others have adjusted limits and changed the rules on how much of your home equity can be spent (and in some cases, what you can spend it on). The new way of doing business is meant to be a safeguard for borrowers if home values drop.
On Sept. 1, 2019, the FHA began limiting cash-out refinancing to a maximum of 80% of a home’s value. For example, for a home valued at $500,000, the maximum loan amount would be $400,000. According to The Washington Post, those limits now match those of Fannie Mae and Freddie Mac for conventional cash-out refinancing.
The lone exception to the rule is doing a cash-out refinance with a VA loan, which doesn’t typically require you to leave equity in your home.
You’re Ready to Pursue Refinancing. Now What?
Cash-out refinancing has become incredibly popular in recent years, with the FHA reporting a 250% increase in cash-out refinancing between 2013 and 2018. A recent article in Forbes reemphasized the wave of popularity in refinancing, but borrowers should know what they’re getting themselves into.
The type of property you’re looking to refinance will impact the rate you receive, the Forbes article noted, with a primary residence getting the best rate. Secondary homes and rental properties get a second-best and third-best tier of rates, and expectations should be tempered accordingly.
Above all, don’t rush off to the bank and ask about a cash-out refinance rate just because current rates are low. You’ll get the best shot at a favorable rate by getting your financial ducks in order before you apply. That can include paying down smaller, revolving debts and boosting your credit score. Also make sure you have financial documents and bank statements available to show a lender you can meet common cash-out refinancing requirements.
If you’re truly considering a cash-out refinance, remember that it can be a great opportunity to leverage your home for cash . If you’re not sure cash-out refinancing is right for you, it’s best to speak with a financial advisor or a loan expert to learn more.
- Black Knight, Mortgage Monitor, Dec. 2019 Report. Accessed from https://cdn.blackknightinc.com/wp-content/uploads/2020/01/BKI_MM_Dec2019_Report.pdf
- Zillow, What is a Cash-Out Refinance? Accessed from https://www.zillow.com/mortgage-learning/cash-out-refinance/
- CNBC, 9 million homeowners could save big time on a mortgage refinance as rates hit 3-year low. Accessed from https://www.cnbc.com/2020/01/31/more-than-9-million-homeowners-could-save-big-money-on-a-refinance.html
- Credit Karma, What is a Cash-Out Refinance? Accessed from https://www.creditkarma.com/home-loans/i/cash-out-refinance/
- Investopedia, What is Risk-Based Mortgage Pricing? Accessed from https://www.investopedia.com/terms/r/risk-based_mortgage_pricing.asp
- Washington Post, FHA sets limits on cash-out refinancing. Accessed from https://www.washingtonpost.com/business/2019/08/27/fha-sets-limits-cash-out-refinancing/