Why Now Is The Time For Cash-out Refinancing

Combine equity-rich homes with a bunch of microbes and now may be the best time for cash-out refinancing since 2012, the year weekly mortgage rates hit 3.31%.

According to ATTOM Data Solutions, the term “equity rich” means that a home’s mortgage balance is not more than 50% of the property’s estimated market value. The company says at the end of 2019 there were 14.5 million equity-rich homes, about one of every four houses with a mortgage.

How did residential balance sheets become so flush? And why is now such a good time for a cash-out refinance? You may be surprised by the answers.

Microbes and mortgage rates

We don’t know where mortgage rates for cash out refinancing will be in the future but we know with certainty where they are today. Mortgage rates are low, very low. Freddie Mac has tracked weekly mortgage rates for decades. See Freddie Mac vs Fannie Mae. Between early 1971 and the end of 2019 weekly mortgage rates averaged 8.0% (7.999%). Mortgage rates as this is written are less than half the long-term norm.

The reason for low rates is that the world has a lot of cash and – surprisingly – not a lot of demand. Bloomberg reported last August that there’s some $15 trillion invested worldwide with negative interest rates. In some cases mortgage borrowers overseas are getting checks from their lenders!

Foreign money is being sent here as investors search for better returns. That’s part of the reason for low rates. But now, in early 2020, the mortgage market is being pummeled by events in China. The Wuhan coronavirus has slowed economic activity in China and that’s a big deal. According to The New York Times, the virus “has shaken companies and investors around the world.”

“In some economically important regions, such as China and the euro area, data through early this year suggested that growth was steadying,” said the Federal Reserve in early February. It warned that “the recent emergence of the coronavirus, however, could lead to disruptions in China that spill over to the rest of the global economy.”

First identified in January, the fast spread of the Wuhan virus has coincided with a sharp mortgage rate decline. For the week of January 2nd mortgage rates stood at 3.72% for fixed-rate, 30-year financing according to Freddie Mac. By February 13th the same loan was priced at 3.47%. That’s a .25% drop, a visible decline when rates are so low.

Whether the coronavirus effect will continue is unknown. Containment — or development of a vaccine — might quickly reduce disruptions created by the virus. For the moment the virus is with us, mortgage rates are near historic lows, and the reality is that a window of opportunity is open. 

Trillions in untapped equity

Most American homeowners – but not all – have an increasingly large amount of real estate equity. Residential real estate was worth $29.2 trillion at the end of the third quarter according to the Federal Reserve. Subtract $10.5 trillion in mortgage debt and you wind up with home equity worth $18.7 trillion.

Homeowners can access this equity with a cash-out refinance. In addition, while refinancing they may be able to lower the interest rate and monthly cost of the mortgage debt they now have in place. There are three basic cash-out refinancing strategies.

  • You replace a current loan with a new and bigger mortgage. Example: You have a $100,000 loan at 4.5% and refinance with a $150,000 mortgage at 3.5%.
  • The current loan remains in place and you get a second mortgage. Example: Your current financing has a $100,000 balance. You like its rate and payments. You get a $50,000 second mortgage at today’s rates and keep the old loan in place.
  • You get a home equity line of credit (HELOC). This is really a second mortgage where you have the right to borrow up to the limit of your credit line. Example: You like your current financing. You leave it in place. You also get a $50,000 HELOC and borrow from it up to the credit limit.

How much cash-out refinancing can you borrow?

How much you can borrow depends in large measure on your property’s existing debt, it’s fair market value, your financial profile, and how much new debt lenders will allow.

Lenders use a loan-to-value (LTV) calculation as one way to limit risk. For instance, the FHA will finance up to 80% of a home’s value with a cash-out refinance. The VA will help qualified vets with 100-percent LTV refinancing. Fannie Mae and Freddie Mac want a 20% equity cushion for a cash-out refinance. Other loan programs – such as “portfolio” loans created by individual lenders – may be available with higher LTVs that allow larger cash-out refinancing.

Cash-out refinancing and cautious borrowers

It might seem as though low rates and gobs of equity should create massive opportunities for lenders. Oddly, that’s not the case. Borrowers aren’t biting, they’re leaving large amounts of equity untouched. The amount of household debt at the end of 2019 was actually lower than in the third quarter of 2008. Homeowners have become financially conservative, they understand that debt needs to be repaid. That’s a good approach to borrowing.

The US loan-to-value (LTV) ratio – the ratio of debt-to-property values nationwide – has fallen substantially. According to the Urban Institute (UI), the LTV for residential real estate is now 35.4% – down from 54.7% in 2009.

UI points out that in the second quarter of 2019 home equity lines of credit – HELOCs – amounted to $399 billion. Back in 2009 the same form of borrowing represented outstanding debt worth $714 billion.

“A declining proportion of homeowners have a mortgage,” said the Urban Institute. “The share of homeowners with a mortgage declined steadily between 2008 and 2017, from 68.4 to 62.9 percent – the lowest level since at least 2005. Conversely, the share of owner-occupied households with no mortgage has climbed to 37.1 percent over the same nine-year period.”

The combination of low rates and reduced lending levels is good news for those who want a cash-out refinance. It means lenders really, really want your business. Why? Because lenders have a lot of fixed costs. More loan volume can help them lower costs per mortgage. Those costs in the third quarter of 2019 amounted to $7,217 per origination according to the Mortgage Bankers Association. 

Cash-out refinancing puts billions of dollars into the pockets of American homeowners every year. It’s real money available to property owners at interest rates that are generally below the interest costs for credit cards, auto financing, student loans, personal loans, and business financing. At the same time, cash-out refinancing is just a small portion of the “tappable” equity found in US homes. If you have equity and need funds to pay for a college education, start a new business, or for other purposes you may need to look no further than your front door to find the cash you need.

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The Ins & Outs of Cash-out Refinancing

Don’t be surprised if 2020 turns out to be a very good year for cash-out refinancing. Homeowners have a huge amount of untapped equity and mortgage rates at the start of the year were near all-time lows. The big question is whether it makes sense to refinance this year. If the answer is “yes” then what is the best approach to take?

American homeowners have a lot of equity

Equity is the difference between your home’s fair market value and the amount of debt it secures. If your home is worth $350,000 and your current mortgage balance is $100,000 then you have $250,000 in equity.

The amount of equity now held by American homeowners is enormous.

  • Zillow estimates that home values increased by $11.3 billion between 2010 and the start of 2020. Some of this figure is the result of new units added to the housing stock but much of it is in the form of higher home prices.
  • Many homeowners have huge amounts of equity. ATTOM Data Solutions estimates that 14.4 million homes were equity rich as of the third quarter. By “equity rich” ATTOM means that mortgage debt was not more than 50% of the property’s fair market value. Alternatively, not everyone is sharing in the good times. Some 3.5 million properties remain “seriously underwater,” properties where the mortgage balance is at least 25% greater than the property’s value. These underwater homes in many cases have simply never recovered from the 2007 housing crash.
  • Mortgage debt has actually declined since the crash even though home values have generally increased. According to the Federal Reserve Bank of New York, mortgage debt amounted to $9.82 trillion in the third quarter. That’s LESS than homeowners owed in the third quarter of 2008. Less debt and higher prices are a sure way to increase equity.

What’s the most cash-out refinancing I can get?

Different loan programs allow qualified owners to obtain different amounts of cash from their properties.

  • FHA financing. Until September borrowers could refinance as much as 85% of their property. Now, however, refinances are limited to 80% loan-to-value (LTV).
  • VA mortgages. New rules in place this year for the VA mortgage program allows 100% loan-to-value refinances for qualified veterans.
  • Conventional mortgages. Fannie Mae and Freddie Mac allow up to 97% loan-to-value ratios for a single-family prime residence when refinancing with a fixed-rate mortgage. Refinance with an ARM and the LTV is limited to 90%.
  • USDA financing. Available in rural areas as well as many suburban communities, refinancing through the USDA program allows as much as 100% LTVs.

Fair market value

Lenders make cash-out loans on the basis of a home’s fair market value. Imagine a home that can sell today for $350,000. Some lenders will see the “fair market value” not as $350,000 but as $350,000 less 8% or so. How come? They figure it will cost money to market the property and pay for closing costs if the home must be sold.

Owners must be realistic when it comes to refinancing. A $350,000 home with a $100,000 mortgage may have $250,000 in apparent equity but the amount available will be less. If a lender subtracts an 8% margin for selling, the property has an effective value of $322,000. A lender might finance 95% of the effective equity. That means the “tappable equity” is $305,900. From this amount the lender will subtract the $100,000 is existing debt. In the end the maximum amount of cash that can be accessed will be $205,900 less closing costs. That’s a lot of money but it’s not $250,000.

Cash-out refinancing: How to get your money

There are several strategies property owners can use to pull cash from their homes. The basic options look like this for a $350,000 property with a $100,000 mortgage balance at 5%.

Refinance your current mortgage. In this situation you replace your present financing with a new and larger mortgage.

Where this gets interesting is when additional money can be pulled from a home with little or no increase in monthly costs for principal and interest. For instance, $100,000 at 5% requires a monthly payment over 30 years of $536.82. Refinance at 3.5%, a rate available in early January, and for the same monthly payment the borrower can get $119,547 with no payment increase. 

If a borrower is willing to pay a little more each month then the amount of cash from closing increases significantly. For instance, with a $600 monthly payment a qualified borrower can get $133,617 in financing at 3.5%. The payment has increased by $63.18 a month in this example while the borrower obtains $33,617 in cash less closing costs.

Get a second mortgage. If your current financing has a low mortgage rate you don’t want to touch it. An alternative way to get cash from your equity is with a second mortgage.

With a second mortgage your original financing remains in place. You then get an additional loan. The new loan is typically ten to 30 years in length and can have either a fixed or adjustable rate. For instance, the property is worth $350,000. You have an existing first mortgage. The balance is $100,000. The monthly payment for principal and interest at 4% is $477.42. You get a $100,000 second mortgage at 3.75%. The loan has a 30-year term. The monthly cost is $463.12. Your monthly mortgage expense is now $940.54 for both loans. Taxes and insurance are extra.

A second mortgage has traditionally had a higher rate because such financing represents more lender risk. If the property must be foreclosed the first loan must be completely repaid before the second lender can get a dime for their loan.

One attraction with a second mortgage is that the original financing remains in place. What started out as a 30-year loan now has fewer remaining years. That means each monthly payment includes a touch more principal reduction and a touch less interest than new financing with the same rate and terms.

It’s possible for a borrower to get a second mortgage at a rate which is equal to or even less than the interest cost for a first mortgage. This can happen if lower rates are generally in place when the second loan is originated.

Take out a home equity line of credit (HELOC). A home equity line of credit – a HELOC – is really just a credit card secured by your home. Typically, a HELOC has an adjustable rate of interest and financing with two phases. In the first phase you can take out money and put money back just like a credit card. In the second phase you must repay any outstanding debt from the first phase and no more withdrawals are allowed.

Borrowers need to be careful with HELOCs. You might get a $100,000 HELOC with a 20-year term. The first phase and the second phase are each ten years in length. At the end of the first phase let’s say $65,000 is owed at a then-current 6%. The monthly cost for principal and interest is $721.63. Why is the monthly payment so high? Because only ten years remains to repay the debt.

Unlike a credit card a HELOC is secured debt. Instead of 17% or so for credit card borrowing, you’ll likely pay something close to today’s mortgage rates. However, since a HELOC is likely to be an adjustable-rate product, the rate can change over time, up or down.

Loan limits

Mortgage amounts are generally capped. Conventional and FHA mortgages have stated loan limits which generally change each year. The USDA program has loan limits determined by income and the number of people in the household. For 2020 the VA has essentially done away with loan limits. This is an important benefit for vets in high-cost metro areas.

However, bigger loans are available. You can refinance with “jumbo” mortgages if the amount you need is above other program limits. Jumbo rates are often lower than the cost of conforming mortgages. That happens because jumbo loans cannot be sold to Fannie Mae and Freddie Mac. As a result, lenders do not have to pay a number of fees and charges. The savings can be passed through in part to borrowers.

“No-cost” refinancing

Sometimes you’ll hear about “no-cost” refinancing. This is a confusing term because there’s a cost to finance and refinance. What the lender means by “no cost” is that some or all of the cash required to pay closing expenses can be added to the debt, paid for by the lender if you will accept a mortgage rate somewhat above today’s usual quotes, or both.

As always, shop around. For individual program details and specifics speak with mortgage loan officers.