Cash Out Refinance Loan

With a cash out refinance loan, individuals replace a current mortgage with a new one that has a higher payoff amount. The extra cash comes from tapping into the house's equity, or the difference between the appraised value of the property and the payoff amount of the original mortgage. People who have lived in the same house for a long time or live in an area of the country where home values are rising, often have a good amount of equity built up in the property. For example, because of a combination of principal payments and increasing values, a homeowner may owe $140,000 on a residence that is appraised at $200,000. The equity amount is $60,000.

Perhaps the homeowner bought the house when interest rates were higher than they are now. To get a better rate of interest, this individual decides to refinance the loan. Knowing that he has $60,000 of equity, he may decide to borrow more than the $140,000 actually owed on the original mortgage. The homeowner applies for a cash out refinance loan for $160,000, or 80% of the appraised value. When the application is accepted, the new lender pays off the original loan and then gives the borrower the remaining funds of $20,000 less any closing costs and fees. Because the homeowner understands the importance of making wise financial decisions, he uses the additional funds to make improvements and upgrades to his property. These projects increase the market value of the home by more than the amount that the individual spent. By following the guidance of Scripture, "I, wisdom, dwell together with prudence; I possess knowledge and discretion" (Proverbs 8:12), the homeowner handled the cash out refinance loan in a wise and prudent manner.

Another homeowner with an identical mortgage situation decides to refinance her original loan to get a lower interest rate. But she decides to borrow $180,000, or 90% of the property's appraised value of $200,000. Because the new cash out refinance loan is more than 80% of the value of the home, the borrower is required to make monthly PMI payments in addition to the house payment. PMI stands for private mortgage insurance and is mandatory whenever the loan-to-value ratio is less than 80/20. At the closing, this homeowner receives a check for $40,000 (less closing costs). Some of the money is spent on home improvement projects, but the majority is used to consolidate old credit card debt and to take a two-week dream vacation. A year later, the credit cards are maxed out again and the homeowner is stuck with higher mortgage payments due to the PMI. Wisdom and prudence were missing from her decision-making process.

As can be seen from the above examples, a cash out refinance loan can help reduce monthly payments and increase the value of one's property. Or it can be a financial mistake. The second homeowner had other options. Perhaps she needed to read books on personal finance to learn how to live within her means so she could get rid of credit card debt once and for all. If the interest rate on her original mortgage really was much higher than current rates, she could have borrowed only the amount needed to pay off the original mortgage without tapping into her equity. If money was absolutely needed for home improvement projects, the homeowner should have determined the cost of these needs ahead of time and only taken enough of the equity to pay for the projects. Her biggest mistake was using equity to pay for items that have no lasting value. Consolidating her debt didn't help because she maxed out the cards again. And she will be paying for that dream vacation for the next thirty years. That kind of dream is really a nightmare. To avoid PMI payments, the homeowner could have applied for a cash out refinance loan that equaled no more than 80% of the home's appraised value and then applied for a second mortgage or a home equity line of credit (HELOC) for any additional funds.

As can be seen from the two examples, prospective borrowers need to consider many factors before applying for a cash out refinance loan. Industry experts suggest that homeowners refinance mortgages when current interest rates are at least a half point less than the interest rate being paid. For example, a homeowner may want to replace a mortgage with a rate of 7.25% if he qualifies for a mortgage with an interest rate of 6.75% or less. Even a more favorable interest rate may not be incentive enough to refinance. If the family plans to move in a few years, the new loan's closing costs may be more than the savings from the lower monthly payments. When the closing costs are calculated, the family may find it is more prudent to leave the original mortgage alone and apply for a second mortgage or HELOC if they need to tap into the equity.

Before agreeing to any specific loan, the borrower is advised to obtain a good faith estimate from the lender. This document outlines all application fees and closing costs, including a calculation of owed taxes and an estimate of the monthly payment. With this type of information, the prospective borrower can weigh all available options without making the mistake of only looking at either the interest rate or the monthly payment. Worksheets and calculators are available at many lending websites that can help prospective borrowers look at the entire mortgage picture. With this type of objective financial information, the homeowner will better understand if a cash out refinance loan is the best option given his individual circumstances.




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