If you need money for things like home improvements, debt consolidation, or investments,Â you may be tempted by a cash-out refinance. That means you refinance with a larger loan than you need to pay off your old mortgage, and take theÂ difference in cash at the closing.
This refinance might be the best and cheapest source of funds, but it could also be an expensive mistake.
Here's what you need to know before youÂ apply.Click to see today's rates (Sep 24th, 2017)
The biggest drawback of most cash-out refinancing is the added fee, and the way lenders calculate it. Fannie Mae, for instance, chargesÂ .375 percent toÂ 3.125 percent of the entire loan amount in risk-based surcharges for a cash-out refinance.
That's right -- you calculate the fee based on the entire loan amount, not just the cash out.
If you want a relatively large amount of cash, the deal may make sense, because mortgage rates are usually much lower than other types of borrowing.
However, if your loan amount is large, and the amount of cash is not, it could be an expensive way to borrow.
Suppose you refinance a $400,000 mortgage, with an additional $20,000 in cash out. If your surcharge is 1.875 percent, that's a cost of $7,875, which is almostÂ 40 percent of the cash you want.
You'd be better off using a credit card or hitting up your local loan shark.
A cash-out refinance is not quick cash youâ€™ll repay fast. Underwriting and eligibility guidelines are stricter forÂ these loans and they canÂ take longer to close than shorter term financing.
For instance, Fannie Mae allows you to purchase or refinance primary homes with 97 percent loans, as long as you don't take cash out. But you can only go to 80 percent if you want cash out.
Loans that require minimum FICO scores of 660 for cash-out only mandate 620 scores for purchases.
It is worth noting that you can avoid the surcharges and stricter underwriting by choosing government-backed refinances like FHA and VA. Those programs have their own sets of upfront fees, though, and they may not make sense if you have significant home equity.
Cash-out refinancingÂ means youâ€™ll have a bigger mortgage and probably a higher payment. You'll also burn up some home equity, an asset just like your 401(k) or bank balance.
This is not something to do lightly.
In addition, takingÂ a cash-out refinance means resetting the clock on your homeÂ loan. You pay more over time by adding those extra years and interest to a new mortgage.
Fortunately, there are alternatives that can be cheaper and safer.
If the reason for your cash-out refinance is consolidation of consumer debt, consider other options before you take out this loan. Depleting home equity to pay of debt accrued buying things that donâ€™t outlast the debt is poor money management.
This method of paying those debts frees up your credit for you to spend yourself into financial trouble again. Then you might be temped to do another cash-out refi to pay this new debt, making this a vicious circle.
Several Federal Reserve studies found defaults on cash-out refinances are higher than for regular refinancingÂ . When home values fell a few years ago, homeowners who had tapped their equity often found themselves owing more than their property was worth.
If either home values or your income drop substantially anytime during the loan term, you could face loss of your home. Without equity, it's very hard to sell if you need to move or if your payments become unaffordable.
The cash-out refinance can be your best choice in these cases:
Ask lenders to show you other options and help you compare costs when you're considering cash-out refinancing.
This is often a better financing strategy if you donâ€™t need a large lump sum for a big purchase or project. A HELOC also makes good sense if you already have ideal loan terms.
With its lower closing costs and added flexibility, a HELOC is usually less costly than a cash-out refinance, and it takes less time to close. There arenâ€™t limitations on its use, and youÂ only pay interest on the amount of credit used.
You can use the funds for any purpose, includingÂ home improvement projects, annual costs like college tuition, or financing a gap in business revenue.
Personal loans, also called signature loans, are faster to process and much easier to get than mortgages. You can use a personal loan for home improvements, debt consolidation, major purchases or other expenses.
Instead of repaying the loan forÂ 15-30 years, youâ€™ll pay this debt off inÂ five years at most.Â The interest rate depends on your credit rating, and will probably be higher than that of a mortgage.
However, the costs are low, and with a shorter term, youâ€™ll still pay less over its lifeÂ than withÂ a cash-out refinance.
It might also improve your credit by adding another line of credit to your credit history. This couldÂ be valuable if youâ€™ve had recent financial challenges that damaged your credit.
If you can improve on the terms of your first mortgage, that doesn't mean a cash-out refinance is automatically your best deal.
Depending on the amount of cash you want, it might be less expensive to refinance your first mortgage with a cheaper rate-and term loans, and then add a second mortgage.
This can be a fixed home equity loan (best when you need a lump sum) or a HELOC (best for ongoing needs over time).
If you have vehicle loans at high interest rates, see if you can refinance them. That will give you lower payments and the you can use the savings to pay other debt.
Look at selling valuable collections, Â luxury items or things youâ€™re not using. If thereâ€™s still debt left after your selling spree, see a credit counselor about restructuring that to pay it off. They also can help you develop better spending habits.
Consider starting a side hustle using high-demand skills you already have. Look for ways to generate income in the gig economy but carefully research their costs and legal requirements.
Borrow from family, applying for zero-interest balance transfer credit cards, or borrow against your 401(k) and deduct payments from your paycheck.
These options reduce your debt load or give you better terms than a cash-out refi or even other credit.
Current mortgage rates for rate-and-term refinances and cash-out refinancing are affordably low. However, you still need to compare options and shop among competing mortgage lenders to pay as little as possible for your next loan.Click to see today's rates (Sep 24th, 2017)
The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.
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2017 Conforming, FHA, & VA Loan Limits
Mortgage loan limits for every U.S. county, as published by Fannie Mae & Freddie Mac, the Federal Housing Administration (FHA), and the Department of Veterans Affairs (VA)