Tapping home equity while refinancing is becoming more of a possibility for many borrowers as housing values across the country continue to increase. The real question is whether homeowners should.
A mortgage refinance happens when the homeowner gets a new loan to replace the current mortgage, often to get a lower interest rate. A cash-out refinance happens when the borrower refinances for more than the amount owed. The borrower takes the difference in cash. Also called a cash-out refi.
In the 2nd quarter of 2015, 34% of refinances were cash-out refis. That occurred as national home prices rose 6.2% year over year.
Still, doubts over cashing out may linger for some homeowners, especially since that’s how many borrowers got in trouble during the last recession and either lost their homes or ended up underwater in their mortgages.
“It’s your house, and you have to be very careful with what you’re doing,” says Michael Moskowitz, founder and president at Equity Now, a New York-based mortgage lender. “For everyone who mortgaged their house to keep a business going, some made a fortune, but there were many people who lost their homes.”
What is it?
A cash-out refinance means you refinance your mortgage for more than the current outstanding balance and keep the difference between the old and new loans. For instance, you want $25,000 to start a business. But you still owe $100,000 on a $200,000 house. You can refinance the mortgage at $125,000 and use the $25,000 in equity you pulled out for your business venture. Depending on the rate you started with, you could end up with a lower rate and a lower payment on the new mortgage, too.
Getting a cash-out refi has its pros and cons:
- Satisfy big expenses
- Improve your debt profile
- More stable rate
- Worse terms
- Cumbersome, and sometimes pricey, process
- Home at greater risk
Pros of cash-out refinances
- Satisfy big expenses: A cash-out refi is a way to access money you already have in an illiquid asset to pay off big bills such as college tuition, medical expenses, new business funding or home improvements. It often comes at a more attractive interest rate than those on unsecured personal loans, student loans or credit cards.
- Improve your debt profile: Using a refinance to reduce or consolidate credit card debt is also considered a cash-out refinance and is a popular option among David Cary’s clients in Northern California. Cary, a mortgage broker for C2 Financial Corp., will look at the weighted average interest rate on a borrower’s credit cards and determine whether moving the debt to a mortgage will get them a lower rate.
“Say a borrower is paying 12% on $80,000 on 3 credit cards. I can move that to the mortgage at a lower rate, so they are paying less to borrow the same amount of money,” he says. Additionally, a borrower can choose to use some of the equity to pay down the debt first. Even better, that debt is tax-deductible. “Generally, an extra $100,000 in debt beyond the mortgage can be written off,” he says.
- More stable rate: Scott Sheldon, a loan officer with Sonoma County Mortgages, says many of his borrowers choose to do a cash-out refinance for home improvement projects because they want a steady interest rate instead of an adjustable rate that comes with home equity lines of credit, or HELOCs. “With HELOCs, borrowers will pay prime plus 2 or 3 (percentage points),” he says. “That’s great right now if you can pay it off before short-term rates go up.”
Cons of cash-out refinances
- Worse terms: While you may get a lower interest rate than your current mortgage, your cash-out refi rate will be higher than a regular refinance at market rate. “Even if your credit score is 800, you will pay a little more, usually an eighth (of a percentage point) higher, than the market. Cash-outs are always higher,” Sheldon says.
- Cumbersome, and sometimes pricey, process: “Get ready,” says Dave Norris, president and chief operating officer for LoanDepot.com. “Prepare how you would for any other mortgage transaction.” That means gathering many of the same documents you did when you first got your home loan: past 2 years of tax returns; past 2 years of W-2 forms; 30 days’ worth of pay stubs; 2 most recent bank statements; and possibly more, depending on your situation.
You’ll also have to pay closing costs at the end of the refinance, which can range from hundreds of dollars to thousands of dollars, depending on a variety of factors.
Home at greater risk: Taking out equity puts you at greater risk of owing more than your home is worth when housing values go down. Several Federal Reserve studies have found that default rates on cash-out refis are higher than those on regular refinances.
And consider this: During the height of the last housing boom, in the 2nd quarter of 2006, homeowners extracted $84 billion in home equity. Cash-out refis represented nearly 89% of all refinances in that quarter. That preceded an unprecedented nosedive in home prices, which eliminated more than half of Americans’ home equity to the tune of $6.73 trillion.
Can I get one?
If you feel confident that a cash-out refi is for you, here are the requirements that will help you score one:
- LTV: The maximum loan-to-value ratio is more conservative for cash-out refis than a regular refinance. Up to a $500,000 home loan, the maximum LTV is generally 80%. Above a half-million dollars (I should be so lucky), it drops to 70%, Cary says.
Outstanding mortgage debt as a percentage of the home’s current market value
Formula: Mortgage amount owed / Appraised value
Example: Alex owes $80,000 on the mortgage. The house is worth $100,000.
$80,000 mortgage / $100,000 = 80% LTV ratio
- Credit score: The higher the score, the better the interest rate on your cash-out refi. The best rates and more leeway on LTV go to borrowers with FICO credit scores above 700, Sheldon says. “If their credit score is under 700, they will pay a half-point to three-quarters of a point more,” he says. “It can get kind of pricey if your credit score needs some remedial work.”
- Appraisal: A low appraisal can derail any refinance, not just a cash-out one. To get the best appraisal, Norris advises homeowners to do small repairs or maintenance jobs before the appraiser comes knocking on the door. Make sure to be there when the appraiser arrives to point out the improvements he may otherwise miss. “An appraiser can say that a roof is in good condition,” he says, “but if you tell him it was just put in, he knows it has 30 years left, which can help the value of your house.”