Some 2.43 million homeowners can reduce their mortgage interest rate by refinancing, according to a recent mortgage report by Black Knight, a mortgage data and analytics company.
One such way to do this is through cash-out refinancing, an increasingly popular way for homeowners to draw equity from their homes while lowering their interest rate. Refi applications have been surging ever since rates started to decline from the 5 percent level in October.
Homeowners may have a small window to snag a lower rate
As mortgage rates continue to slide, homeowners who were locked into rates north of 5 percent can benefit; especially if their credit has improved and they now qualify for a lower rate. In fact, experts predict that sub 5-percent rates will persist throughout 2019, according to a recent survey by the American Bankers Association.
But that may not last. According to the 15 economists who took part in the survey, the 30-year fixed-rate mortgage will steadily climb. They predict a 4.6 percent rate in the first quarter of 2019, up to 4.7 percent by Q2, then 4.86 percent in Q3 and, finally, ending the year at 4.91 percent. They also predict rates of around 5.05 percent in the first quarter of 2020.
For homeowners who might qualify for a lower interest rate, this could be one of their last chances to get a better deal on their home loan before rates tick up again.
How cash-out refinancing works
The way cash-out refinancing works is that you refinance your mortgage for a larger sum (more than what you owe) and, ideally, lock in a lower interest rate than your current one.
Most lenders will extend a line of credit of up to 80 percent of the home’s LTV. For instance, if your house is valued at $250,000 and you owe $150,00 then you have $100,000 in equity, which means you might qualify for a $50,000 loan. Your new mortgage will go from $150,000 to $200,000 if you take the full amount you qualify for.
One of the best ways to ensure that you get a good deal when you refinance is to make sure your credit (FICO) score is strong.
The higher your FICO score the more competitive your rate will be. For instance, borrowers with a FICO score between 660 and 679 will pay about 40 basis points more than someone with a better FICO score of between 700 and 759.
Along with credit checks and employment verification, cash-out refinances are also similar to first mortgages in that borrowers usually must pay closing costs. Like first mortgages, closing costs are 3 to 6 percent of the total mortgage amount.
So, if closing costs are 3 percent, it will cost $5,700 to refinance your existing loan. This is a powerful reminder that the math should check out before you make up your mind on a cash-out refi.
When cash-out refis make sense
Homeowners who use cash-out refis to make repairs or upgrades can deduct the mortgage interest from their federal tax returns while reinvesting money back into the home. This might be a good option, particularly if they can lock in a lower rate.
Pulling money out of your home to pay off high-interest debt might make financial sense, but first make sure the math checks out, says Greg McBride, CFA, chief financial analyst at Bankrate.
“Cash-out refinancing is beneficial if you can reduce the interest rate on your primary mortgage and make good use of the funds you take out,” McBride says. “Keep in mind that the repayment on whatever cash you take out is being spread over 30 years, so paying off higher-cost credit card debt with a cash-out refinance may not yield the savings you’re thinking. Using the cash out for home improvements is a more prudent use.”
If you have significant debt with double-digit interest rates, then it’s worth it to crunch the numbers to see if you come out better refinancing your house and paying off the debt that way.
“A 30-year fixed cash-out mortgage in most cases is still under 5 percent, which is substantially lower than credit card debts at approximately 20 percent or student loans, which are now at more than 5 percent,” says Shashank Shekhar, CEO of Arcus Lending in San Jose, California.
Homeowners with cash-flow problems because of short-term installment debt might also benefit from combining their car loans and credit card debt into their mortgage to get a lower monthly payment.
“If, after a point of time, cash flow is not a concern anymore, they can take the monthly savings and invest it back into the mortgage by making an extra payment towards their principal balance, thus paying off their mortgage faster and saving on the interest cost,” Shekhar says.
However, this could also result in paying more interest overall or extending the debt over a longer period of time, so it’s important to look at the numbers and discuss this option with a financial advisor.
Keep in mind that it doesn’t make much sense to finance a car that will be used up in six or eight years with mortgage debt that extends to 30 years.
When cash-out refis may be a bad idea
Cash-out refinancing calls for caution if doing so increases the rate of your existing mortgage, if it puts you back into paying PMI after you’ve shed it, or if it means dragging out the repayment of an existing debt for decades when you could have paid it off much sooner and at a lower total cost otherwise, McBride says.
A loan calculator will help you determine the total interest cost of that added debt versus another option.
“A short-term, higher-rate loan may result in lower total interest cost than a three-decade repayment at a low mortgage rate,” McBride says.
Folks who drain their equity to pay for things like vacations and entertainment could be digging themselves into a hole. This is especially true if you refinance into another 30-year home loan — setting back the clock and dragging your mortgage well into retirement age. This is a high cost for spending that hurts you financially.