Cash out refinances become became commonplace in the early to mid 2000′s as property values seemed to double or triple over the course of just a few years. Now, post sub-prime crisis, most banks have reverted to more stringent underwriting requirements, making cash-out refinances harder to obtain. For those who do qualify, a cash-out refinance can be an important part of your overall personal financial plan.
How a Cash Out Refinance Works
One of the most common underwriting criteria banks use to qualify a borrower for a mortgage is the loan to value ratio (LTV), which is a ratio of the loan amount to the value of the property. A LTV of 80 percent means the loan on that property encumbers 80 percent of the value of the property. Another to way to view it is: a borrower seeking an 80 percent LTV loan on a property valued at $200,000 would be able to borrow $160,000 ($200,000 x 80 percent).
Suppose you qualify for a loan like the one used in the example above, $160,000 on a property valued at $200,000 (80 LTV), but the current outstanding loan balance which you are refinancing is only $140,000. That means there is a difference of $20,000 between what you need to refinance and the amount for which you qualify. That money, $20,000, represents the amount of cash you could pull out from the equity in your home. The old loan of $140,000 is replaced with a new loan of $160,000 and you receive a check for $20,000 at the loan closing.
When Does a Cash Out Refinance Make Sense?
Cash out refinances work best in stable or well-performing real estate markets, and should only be performed when you have the opportunity to put yourself in a better financial position. Cash out refinances work particularly well to payoff high interest debt like credit cards or auto loans.
For example, when paying just the minimum ($200) each month, a $10,000 credit card balance at 19 percent will take you 100 months to payoff; and that’s if you don’t add to the balance. Another example: a five year $10,000 car loan at 9 percent will cost you approximately $207 per month.
Using a cash out refinance to pull an extra $10,000 out of the equity in your home (under a 20 year loan at 6 percent) will cost you only $72 per month, a savings of between $128 to $135 per month when compared to the credit card and car loan.
It’s All in the Numbers
Keep in mind, your home loan is probably amortized over a much longer period of time than your other revolving or personal debt items. While a cash-out refinance may represent a short term savings, it has the potential to cost you more money over the long term if that loan stays in place. Let’s look again at the example above. Over the five years of having the car loan you will have paid a total of more than $12, 000 ($207 x 60 monthly payment). However, using the cash-out refinance the extra $10,000 will cost you a total of $17,000 ($72 x 240 monthly payments) over the loan’s 20 year term. As you can see, the cash out refinance, though it lowers your monthly payment, ends up costing you $5,000 more than the car loan, in the long run.
A long term home loan may cause you to pay more in the end, but if your main goal is to lower your overall monthly payments in the short term, the cash out refinance may be worth the cost. For some people trying to balance their budget, lowering their monthly payment may be a necessity, at which time a cash out refinance, if available, may be a lifesaver.
When researching cash-out refinance options you need to consider both the short term and long term ramifications. Always ask your lender to break down for you, in writing, any incremental cost savings as well as long term loan costs of a potential cash out refinance. Be sure to run both scenarios into a personal budget. If you don’t have a budget, create one for free at JustThrive.com .
To view current refinance loan rates and to request information for a cash-out refinance visit LendingTree.com.
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