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Is a cash-out refinance right for me?

Cash-out refinanceIf you are looking to take advantage of historically-low mortgage rates to tap the equity in your home, a cash-out refinance may be right for you.

A nationwide rebound in the housing market has lifted home values, and millions of Americans now have more equity in their homes. In fact, in the last two years, home equity has grown by an estimated $3 trillion, according to the Federal Reserve.

The growth of home equity is prompting more homeowners to take cash out of their homes to fund home repairs, college tuition payments and other costly endeavors. 

What is a cash-out refinance?

In a cash-out refinance, you refinance an existing mortgage loan with an even larger loan. You can take the difference between the old and new loans and spend the extra money however you see fit.

"Cash-out refinances work best in situations where you can lower the rate on your mortgage even as you increase the loan balance," says Keith Gumbinger, vice president of HSH.com.

Most cash-out refinances have a longer payment term than the original loan, Gumbinger says. "This helps to limit any rise in the monthly payment, helping to keep the new mortgage affordable.”

Fannie Mae and Freddie Mac allow homeowners to borrow up to 85 percent of the value (15 percent LTV) of the home, but private lenders, concerned about risk, may allow even less.

For example:

If you bought a home for $200,000 and still had $150,000 left on the mortgage, a cash-out refinance would allow you to take out a new loan at $170,000 – hopefully at a lower interest rate than the original loan – and pocket the $20,000 difference.

In terms of interest rates, Gumbinger says borrowers with exceptional credit can expect to find interest rates on cash-out refinances backed by Fannie or Freddie ranging anywhere from 0.25 percent to a full percentage point higher than those for regular rate-and-term refinances.

Is a cash-out refinance right for me?

Just as with any loan, there are times when a cash-out refinance makes financial sense, and other times when you are better off choosing a different product.

A cash-out refinance has to be worth it financially, says Gumbinger. "You won't get any benefit from the transaction if adding $5,000 to your mortgage balance costs you $5,000 in fees. And it doesn’t make sense to refinance if the interest rate would rise as a result of the refinance.”

In addition, a cash-out refinance may not make sense if you have to borrow more than 80 percent of your home's value. In such cases, you would need to purchase private mortgage insurance (PMI), which can be costly.

"This could easily wipe out all the benefit of getting the use of those funds," Gumbinger says. "So you'll need to consider those costs in your calculations."

Cash-out refinance calculator

HSH's Tri-RefiTM refinance calculator can help you decide which financing strategy is best for you – be it a traditional, low-cash-out or cash-out refinance. Input your mortgage parameters and calculate how much each option will cost or save you over time.

Cash-out refinance vs home equity loan

A cash-out refinance is different than a home equity loan or line of credit. A cash-out refinance gives you a new first mortgage that replaces your original loan.

By contrast, a home equity loan is a separate loan that rests on top of your mortgage loan. It provides a lump-sum of cash, and you then make payments over a fixed term.

A home equity line of credit works more like a credit card, where you borrow and repay funds over time.

Most home equity products will let you borrow up to an 80 percent total loan-to-value ratio (TLTV). This is the combination of your first and second liens as a percentage of the value of the property.

Compared to a cash-out refinance, you might be able to leverage slightly more money out of your property by using a home equity loan or line. But in general, a cash-out refinance will give you a lower interest rate and longer available terms than a home equity loan.

Low-cash-out refinance

One type of cash-out refinance – a low-cash-out refinance (also known as a limited-cash-out refinance) – allows you to avoid paying all of the closing costs up front. Instead, any costs not covered at closing are tacked onto the remaining loan balance, and can be paid over time.

"This can be a painless way to lower your mortgage's interest rate and your monthly payments without emptying out your savings," Gumbinger says.

If you have more immediate uses for your money or do not have enough savings to cover refinance costs, a low-cash-out refinance may be your only option.

The chief disadvantage of a low-cash-out refinance is that you will need extra home equity to roll your costs into the new loan. 

Also, if your loan today does not require mortgage insurance, the last thing you want to do is raise your LTV to the point that you need to purchase such insurance.

FHA cash-out refinance

If you decide that a cash-out refinance is best, make sure you follow the rules. The Federal Housing Administration (FHA) has the following requirements for a cash-out refinance:

  • No late payments on any existing mortgage in the last 12 months
  • You can borrow up to 85 percent of the value of the home (your income will actually determine how much you can borrow)
  • And a low FICO score does not produce a penalty in the interest rate or fees. The FHA will technically back loans with FICO scores down into the 500s, but add-ons from wary lenders usually mean the FICO-score minimum is 600 or even higher.

All FHA loans require mortgage insurance, which can be a little pricey and is non-cancelable.

(Keith Gumbinger and Gina Pogol contributed to this article)

(Image: KLH_49/iStock)

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