Over the life of a mortgage loan, a homeowner makes hundreds of monthly payments to get a clear title to his house — if you have a 25-year amortization on your loan, you’ll make 300 payments. This is a lot of money that loses its liquidity which, for many people, does not make financial sense. If you want to buy a boat or a vacation home, you can’t sell the stairway or the roof to your house in order to pay for it. However, banks have come up with equity loans and home equity lines of credit, and even reverse mortgages to help homeowners access the money that they have tied up in their homes. Another way to get to that money is known as cash-out refinancing.
Here’s how it works. You go to the bank or lending institution and agree to refinance the loan for more than your current balance. Then, the bank writes you a check for the difference — less closing costs and applicable fee. So, let’s say you still have a mortgage balance of $160,000 on a house that you bought for a purchase price of $275,000, and today the appraised value is $300,000. You want $40,000 in cash because your child is about to go off to university, and you want to help with the tuition. So you would go back and refinance for $210,000. The closing costs average about 5 percent of the loan. The $10,000 would roughly cover the closing costs, you would still owe $160,000 on the house, and you’d walk out with a $40,000 check.
Cash Out Refinance Rules
There are some key differences between cash out refinancing and home equity loans.
1. The home equity loan is a separate mortgage in addition to your first note, but a home refinance cash out replaces your first note with a new mortgage.
2. The interest rates may differ for a cash out refi vs home equity loan. If your credit is excellent and the appraisal comes back within guidelines, the interest rate may be slightly lower than it would be on a home equity loan.
But what if interest rates are higher now than they were when you took out your first mortgage? It doesn’t make sense to refinance the whole balance at a higher interest rate. In this case, a home equity loan may be your best bet. Also, if you’re five or six years into a 25-year amortized loan, refinance might make some sense. However, if you’re 15 years in, your payments are primarily principal, so refinancing might not make as much sense — why would you drive your interest expense back up?
Another thing to consider is whether you existing mortgage is closed, open, fixed or variable. Depending on the type of mortgage you have in place may determine your pre-payment penalty. Is it an IRD (Interest Rate Differential) calculation, 3% of the balance remaining, or simply 3 month pre-payment interest?
Cash out refinance vs home equity line of credit
Is cash out refinancing or a home equity loan the right answer?
The answer depends on how much you need, how far you are into your mortgage, what you want to use the money for, and the relative interest rates available. Consider the example of Dudley and Nell Doright. They bought a house for $520,000 at a fixed rate of 4.8 percent in 2010, putting down $120,000. Their monthly mortgage payment with a 25-year amortization (not counting insurance or taxes) is $2,291.99. A couple of years later, rates have dropped to 3.4 percent, and they want to take $20,000 out for a surgery for Nell.
Five years later, the balance has dropped from $400,000 to $352,000. They want to refinance to get $20,000 out. Adding $10,000 in for closing costs, they need a new loan for $382,000. Even keeping the same amortization schedule (so a 20-year schedule, leaving their paid-off date the same) yields a slightly lower payment at $2,195.87. If they want a new 25-year amortization, the monthly payment is $1,891.96. Because of the drop in interest rates — and because they are still relatively new in the mortgage — it makes sense to do the cash-out refinance.
Because there are so many variables at work in each mortgage, you will definitely want to run the numbers on your various scenarios before signing the paperwork on a loan. Interest rates and closing costs are numbers that have a way of sneaking up on people at the worst time. As a result, you want to know exactly what you’re in for, and you don’t want to be afraid to compare lenders. Your lender might try to stick you with higher closing costs, thinking that you won’t shop your loan around. If you make your lender aware that you’re looking around, you are more likely to get a competitive offer. After all, they like getting checks from you every month! Contact Amansad Financial Services to see if what is best for you.
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