Cash Back Refinance Basics
A cash back or cash out refinance is when you refinance your current mortgage loan. The new loan that replaces it is for a bigger amount than the current loan. You then get the difference between the two cash out loans. People do this so that they can pull out some of the equity in the home so they have cash for various purposes.
For example, say you have a $300,000 home and you owe $200,000 on the loan. You actually own $100,000 of the home; that is your equity. If you want to pull out $30,000, you can do a cash back refinance loan to get this cash. So, your new loan would be for $230,000. You will need to make regular monthly payments on the $30,000 you borrowed, just like the other $200,000 you pay on.
So that is how a cash out refinance basically works. But what are some of the secrets and in’s and out’s of a refinance? Keep reading.
#1 Cash back refinances aren’t free
You need to pay closing costs on the new loan just like any home loan. This can cost several thousand dollars up front. If you plan to sell your home in a year or two, you may not want to do a refinance as the cost can be too high for the short term you will still own the home. In some cases mortgage companies may offer you a cash back refinance with no closing costs. When shopping cash refinancing options make sure the interest rates are competitive when the lender proposes a “no cost” loan.
#2 Use the cash for something that turns a profit
Many people use a cash back refinance to pay off debt or to go buy something, such as a car. There are defenses for these types of financial choices; if you are paying 20% interest on $30,000 of credit card debt, you could be paying 4% interest or lower with your new mortgage loan. The cash out loan is for the responsible homeowner looking to leverage equity. But buying a car or another depreciating asset often does not make sense. You are paying interest on that money every month, so should you really plow that money into an asset that loses value at the same time?
Instead, consider using your equity to make wise improvements in your home that will pay you when the sell the home. You could upgrade your kitchen or bathroom and this may allow you ask for a higher price when you sell. Or, consider buying real estate investment property and rent the properties out. Done wisely, this can net you 10% ROI per year or more.
#3 Cash back refinances have restrictions
Many lenders will not allow you to borrow in some scenarios. The most common limitations will include:
- Minimum credit score is required. Most lenders will require you have at least a 680 credit score, although you may be able to find one with a lower limit.
- You probably will have to have owned the home for at least one year.
- Maximum loan to value to refinance may be a maximum of 85-90%.
#4 Other options could be cheaper
There are scenarios where you would not want to refinance your loan into another loan. The cost of refinancing are something you have to weigh. Also, if you already are in a low interest loan, you certainly would not want to refinance into something with a higher interest rate.
You may want to think about home equity loan or a home equity line of credit (HELOC). Both of these allow you to tap your equity by taking out either a loan or a line of credit from the mortgage you already have. The rates on these loans are variable, so whether you choose to do this or to refinance and get cash back depends upon your needs.
The interest rate on a cash out refinance will be lower, but your closing costs could be greater. Consider the total costs and big picture before committing to cash back refinancing.
#5 Get a good faith estimate
All lenders should provide you with an estimate of your closing costs and other loan terms within 3 business days of receiving your application for a loan. This is a very good thing because it helps you to avoid hidden closing costs. You should go through the good faith estimate very carefully and make sure you are not being charged anything you shouldn’t be.
#6 You may end up paying longer on your mortgage
If you have been paying on a 30 year loan and you refinance after three years, you are paying for your home for 33 years, and not 30. You also could pay more in interest. You should think more about trying to own your home free and clear faster, and not always what gives you the lower payment right now. So, think about refinancing into a 15 year mortgage to pay off your loan faster, if you can afford the payment. If you can afford the payment, it make sense to choose a 15 -year term on the cash back refinance loan because of the reduced rate and financial freedom created by owning your house in 15-years rather than 30-years.
#7 Shopping around for a mortgage can pay off big
Doing a cash back refinance is a major decision and it can be easy to save on fees if you look around. It also is easy to find a lower rate but you have to shop around. Some people won’t bother to shop several lenders to compare their closing costs and interest rate but they would go to another grocery store to save .50 on a gallon of milk.
#8 A no-cost refinance will cost you
You may have heard about no cost, cash back refinance loans. Everything costs something, it’s just a matter of how you pay it! In the case of a no cost loan, you are going to probably pay a slightly higher interest rate that will make you pay the closing costs over time, plus some. Or the closing costs are being wrapped into the loan amount.
Either way, you are paying closing costs. If you don’t pay them cash up front, you are paying them with interest, so think carefully about which makes the most sense for you.
How Does Cash Out Refinancing Work?
For millions of homeowners, one of the benefits of ownership is being able to pull cash equity out of the home when needed. There are many ways to access that equity, but one of the most popular today is the cash out refinance.
Cash out refinancing occurs when the homeowner obtains a new mortgage to replace the current one – for an amount higher than what is currently owed. The homeowner then may use that cash for what they like, whether it is paying for college, doing a home renovation or paying off credit cards.
A cash out refinance is different than a regular mortgage refinance. The latter is replacing the old loan with a new loan with a lower rate and possibly a different set of terms. You might do a traditional refinance from a higher rate into a lower rate and convert to a 15 year mortgage. You are not pulling cash out of the home in this case.
Over the last decade, cash out refinances have taken a beating in the press. During the market crash, many homeowners pulled cash out of their home to survive the downturn. For many of them, it was delaying the inevitable and they lost their home.
After the crash, lending standards for cash out refinance loans got stricter, and today only 17% of all mortgage taken out yearly are cash out refinances. Ten years ago, 80% of refinances were cash out.
Today, home values have mostly recovered, and cash out refinances are growing in popularity. Is this a good idea for you? Keep reading to learn more.
Benefits of Cash Out Refinancing
- Boost credit score: If you use your equity to pay off credit cards, you will increase your credit score. Credit card debt is viewed more negatively by the credit bureaus than mortgage debt. Mortgage debt is secured by your home, so you are more likely to stay current on your home. Doing this once or twice in your life is ok, but if you are constantly pulling cash out of your home to pay off debt, you are shooting yourself in the foot long term. Think of this: Do you want to be paying a high mortgage when you are 80 years old?
- Consolidate debt: When you pay off credit cards, your credit utilization drops and this will also pull up your score.
- Write off the mortgage interest: If you pull out cash, you will be able to write off that mortgage interest from your taxes in most cases. This can save you $1000 a year or more.
- Use the cash to renovate the home. If you do a wise renovation with your equity, you can pay yourself back with a higher home value. Make sure you keep the improvements to things that are shown to pay, such as a renovated kitchen or bathroom.
- Use equity to pay for college expenses. In many cases, you can pay a lower interest rate on your mortgage than you can on college loans.
Cash Out Refinance Cautions
Remember that you are putting your home on the line with a cash out refinance. You want to be sure you are using your equity for a good purpose. If you are paying off debt, investing in a business or rehabbing your home, this can be a good thing.
But if you are using equity to buy yourself a luxury car that will only decline in value, you are probably wasting your equity. And you are risking your home for short term pleasures.
If you are too tempted by a pile of cash, you may want to just get a regular refinance without pulling out cash.
Interest Rate Changes
Today’s interest rates are still around 4%, so you may be able to benefit from doing a cash out refinance into a lower rate. If your loan is from a decade ago, there is a good chance you could be able to save money on your monthly payment.
However, some people may not be able to get a lower rate than they have now. If that is the case, you may not want to refinance. It does not often make financial sense to do a cash out refinance at a higher rate than you are paying now.
Remember Closing Costs and Fees
Any time you do another mortgage, you do another round of closing costs and fees. This could run you several thousand dollars. You should carefully review your closing costs and how you are going to use those funds.
Most homeowners refinance to get better loan terms. But if you are refinancing into a higher rate to pull out cash, the costs may outweigh the benefits.
In this situation, you may want to get a HELOC (home equity line of credit) or home equity loan instead.
As with most financial products, there are good and bad uses of cash out refinances. We think that you should do a cash out refinance if you can get a lower rate and you have a legitimate use for the equity that will improve your long term finances. Examples might be paying off high interest debt (IF you are not going to run up more debt!), investing in cash flowing real estate, or paying for a college education.
If you have a good purpose for that money, a cash out refinance could be a great way to improve your financial standing.