When a homeowner chooses to do a cash out refinance, the new mortgage balance will comprise of the your old loan balance plus the desired cash out amount. This kind of refinance is often referred to as a cash out refinance.
Take a look at the following example in which John R. wants to pull $40,000 out of his home as a cash out refinance:
In the previous example John has a present mortgage of $200,000. The home has appraised for $300,000, so John has $100,000 in equity.
John basically owns 33% of the current properties appraised value and the bank owns the other 66%. If John wishes to tap into that equity, he can execute a cash out refinance.
Numerous property owners end up using cash out refinances for debt consolidation home improvement. Instead of paying a 20% interest rate or higher on a credit card each month, you can pay off that balance using your mortgage and pay a rate of 5-8% instead.
The major downside to this is when homeowners get into what is called the merry-go-round cash our refinance. This happens when homeowners continually use the equity in their homes to help pay for a lifestyle they simply can not afford, running credit cards up and then paying them off with the equity in their homes over and over in a vicious cycle.
Other homeowners might pull cash out in order to make home improvements that promise to increase the homes appraised value significantly, thus lowering their overall loan-to-value and increasing the equity in the home.
Others might do a cash out refinance if they believe it is possible to invest that money at a better rate of return than the interest rate on your mortgage, the spread between your mortgage interest rate and your investment interest rate is the potential profit.
We do not ever advise homeowners to jeopardize their homes on just investment endeavors.
One of the questions you should ask yourself is whether or not it makes financial sense to refinance your current mortgage. Keep in mind that there are fees connected with a second mortgage, and thousands more if you are planning on a cash out refinance by refinancing your first mortgage and taking cash out.
While cash-out refinances may provide homeowners with essential help in a serious situation, when you cash out, you are resetting your mortgage and losing all the equity you’ve potential spent years building.
You not only lose your equity, but you take on more debt, which reduces your net worth even further.
Many mortgage lenders will not let homeowners do cash-out refinances on their property without twelve months of seasoning. This means that if you purchase a home, you’ll need to sit on it for at least twelve months before trying for a cash out refinance.
There are some mortgage lenders who will allow cash out refinances up to 80% loan-to-value without twelve months proper seasoning, but many homeowners who are looking for a fast cash out refinance usually don't have the needed 20% equity in their properties.
Also, you should keep in mind that a refinance will be considered cash out if a homeowner refinances a non-purchase money home equity line of credit.
If you open an equity line after the original purchase transaction and then later want to refinance it, it will be considered a cash out refinance even if you aren’t taking cash out at that particular time. What this means to the borrower is price adjustment to the interest rate when they refinance.
It’s not the end of the world, but something to consider as your interest rate will be high after the price adjustments.
To be exempt from this price adjustment you will need to show proof that the previous equity line was used to add value to the house such as a pool or addition.
Most homeowners also feel if they are not actually getting cash in their pocket, their refinance isn’t considered a cash out. This is completely false. If you pay off credit cards or school loans and receive zero cash in hand, the mortgage lender will still consider it a cash out refinance.
With any mortgage refinance, it is essential to figure the costs involved and the primary motive. You should really avoid merry-go-round refinancing as your helping your current situation but killing your future.
Apart from the costs associated with refinancing, your 30 year mortgage will reset to 30 years every time you refinance making it impossible to payoff the mortgage. You end up paying more interest than if you simply left the mortgage alone.
That is why a refinance or cash out refinance should only be reserved for times of tremendous need, or in times when interest rates are simply too good to pass up.