One advantage of a plain vanilla refinancing is that it usually offers a slightly lower interest rate than a cash-out refinancing. Another major plus of this type of refinancing is that you aren't significantly increasing your outstanding mortgage debt.
That said, cash-out refinancing can be more appropriate to accomplishing certain goals, such as paying off debt.
Whatever the pros and cons of the two major types of refinancing, homeowners have expressed a clear preference for cash-out refinancing. In the third quarter of 2008, 78 percent of refinancings backed by Freddie Mac were cash-out refinancings.
Managing costs
While a refinance can help you harvest more cash, it's important to watch out for costs that eat into those savings.First, recognize that there's no such thing as a free lunch, and there's no such thing as a "no closing cost" mortgage. The originating lender will get paid for its efforts; it's just a matter of how they get paid. Closing costs can be paid in origination points, a higher interest rate or a higher loan amount.
Points come in two flavors, discount and origination. Discount points allow the borrower to prepay interest expense upfront and buy down the nominal or stated rate on the mortgage loan. The points paid are, however, considered in calculating the annual percentage rate, or APR, on the loan.
Tip: Get a rate lock
Locking in your refinancing rate provides a guarantee of savings. Bankrate's "
Compare Interest Rates" feature provides the lender's standard rate lock terms, which are typically between 30 days and 60 days. A rate lock that isn't in writing isn't worth spit, much less a handshake. The Bankrate feature "Rate locks explained" gives additional background on this decision.
Buying down an interest rate on a mortgage by paying points doesn't make sense unless you're fairly certain you'll be in the home long enough to guarantee an economic benefit from paying the points. The Bankrate interactive worksheet, "Which rate/points combination is right for you?" will help you decide whether you should pay discount points at closing.
Don't forget about other expenses, such as private mortgage insurance. If your loan-to-value ratio is more than 80 percent of the appraised value of the home, the first mortgage lender will want you to pay for PMI. That adds to the cost of the refinancing. Piggyback mortgages, like an 80/10/10 mortgage, will let you avoid PMI, but you'll have to deal with the vagaries of a second mortgage as part of the refinancing package.
Avoiding junk fees can keep down your closing costs and improve the return on refinancing. The Bankrate feature "A close-up look at closing costs" provides a nice overview of the topic. The HUD "Mortgage Shopping Worksheet" provides a framework to compare them on an apples-to-apples basis.
Dr. Don Taylor is an assistant professor of business administration at Penn State Brandywine in Media, Pa. Each day, he answers reader questions about personal finance in Bankrate's "Ask Dr. Don" column.