If you are thinking about refinancing your mortgage, you might be wondering about your options. Depending on your needs and financial goals, you could be looking at either rate-and-term refinance or cash-out refinance.
Both types of refinancing options could be advantageous. Each has its advantages and disadvantages. Instead of competing with each other, they serve different needs. Here’s a look at what each refinancing option could mean for your situation:
What is Rate-And-Term Refinancing?
If you compare currently available mortgage refinance rates to the interest that you are paying on your mortgage, there is a chance that you are paying a higher interest rate than you should. If you qualify to refinance your mortgage at a lower interest rate than what you are paying now, that might be a signal that it’s a good time to further investigate refinancing. Lowering your interest rate even a few points, you could save a significant amount over the life of your mortgage.
With Rate-and-Term Refinancing, you are not changing the amount you owe on your mortgage – you are changing the interest rate or length of time left on your mortgage. You could also think of it as a “no cash-out refinance” because you are not taking any money out with this type of refinancing.
Will your monthly payment be lower? Perhaps. For example, if you have a 30-year mortgage and you refinance to a new 30-year loan with a lower interest rate, your monthly payment could be lower.
Or you might opt to refinance to a shorter-term mortgage – you could go from a 30-year mortgage to a 15-year loan, for example. In this case, your monthly payment might be somewhat higher, but you could have your mortgage paid off sooner. Depending on your situation, refinancing could ultimately save you money on the total amount of interest you pay during the life of your loan.
What is Cash-Out Refinancing?
Some homeowners with a substantial amount of home equity may be interested in cash-out refinancing. With this option, you might be able to refinance your home and convert some of your equity into cash that you could use for a home improvement project, debt consolidation, or for anything else you wish.
Cash-Out Refi Example
Orlando resident Ashley is one of the thousands of homeowners who took advantage of a cash-out refinancing. Ashley had $96,268 in equity on her home valued at $250,000 and a balance of $153,732 on her home mortgage. She needed to consolidate $35,932 in credit card debt that had an interest rate of about 21%. With her cash-out refinance, Ashley was able to consolidate her credit card debt while lowering her monthly payment by $562*.
With a cash-out refinance, your monthly mortgage payment could increase because you are adding the amount of cash you are taking out to your loan balance. But your total monthly payments would decrease if you use the cash to consolidate high-interest non-mortgage debt.
Also, keep in mind that you still need to qualify for a refinance. Check with your lender what loan-to-value ratio required for a mortgage refinance. Income, employment, credit, debt, and other factors are considered during the application process. Contact a mortgage professional to find out more about the requirements to qualify for a mortgage refinance.
Each person’s situation is different, so take some time to look at your numbers and speak with an expert mortgage professional. Your payment could depend on current refinance rates, the total amount you owe, and other factors. You might find that cash-out refinancing gives you a way to tap into your home’s equity and get a lower interest rate at the same time.
What is the difference between a cash-out refinancing and a rate and term refinance?
If you are thinking about refinancing your mortgage, you have two options. If you want to refinance your current mortgage to change the terms or get a lower interest rate, the process is called a rate-and-term refinance. If you want to use the equity in your home to extract some cash – perhaps pay off high-interest credit card debt, remodel your kitchen, or pay for a college education you may be interested in cash-out refinancing.
Cash-Out vs. Rate-And-Term Refinance
The easiest refinance option is rate-and-term. With the rate-and-term option, you are not cashing any of your home equity. You are only paying the fees and costs associated with the home loan. The size of your home loan remains the same. You are basically trading your current mortgage terms for newer (hopefully more favorable) terms.
With a cash-out mortgage refinance, however, your new mortgage will be bigger than the old one. You are taking equity from your home as cash payment along with new loan terms.
It is possible to qualify for a rate-and-term loan with a higher loan-to-value ratio. The loan to value ratio is the amount of the mortgage divided by the appraised value of your home.
Cash-Out Refinancing is More Expensive Than Rate-And-Term
When you use a cash-out refinance, you can expect tougher terms. If you want to cash-out some of the equity you’ve built up in your property, it’s going to cost you. How much it will cost you depends on your credit score and the amount of equity you have built up in your home.
Why the tougher loan terms and higher cash-out refinance interest rates? Lenders consider cash-out loans a higher risk. A borrower is more likely to walk away from a property after taking some of the equity out of it. It is especially true if the homeowner has pulled out more cash than he initially invested in the down payment. To reflect that risk, a cash-out loan is priced higher until there is so much equity that the homeowner is unlikely to walk away from the property.
Is a cash-out refinance always more expensive?
Under certain circumstances, a cash-out home loan may not have tougher terms. A lower loan-to-value ratio or higher credit score can shift the numbers considerably in your favor. If your credit score is 750 or higher and the loan-to-value ratio is below 60%, for example, you might not be charged any additional cost for a cash-out home loan. The reason being is the lender would believe that you are no more likely to default on the loan than if doing a rate-and-term refinance.
Your mortgage may be a cash-out loan even if you don’t get any cash. If you’re paying off auto loans, high-interest credit cards, or any other debt that wasn’t originally part of your home loan, the lender reasonably considers it a cash-out loan. If you’re consolidating two mortgages into one—and one was originally a cash-out home loan—the new consolidated loan replacing the old loan will also be identified as cash-out.
Does cash-out refi hurt your credit score?
In addition to the higher interest rate, there is another reason to think twice about cash-out home loans: A cash-out refinance can negatively affect your FICO score. When you replace your old home loan with a new one with a larger loan balance you are increasing your credit utilization ratio. Credit utilization is an important part of your overall credit score, it is about 30 percent.
Deciding What’s Best For You
When looking at refinancing options, you might want first to consider what you hope to achieve. Are you looking for ways to lower your monthly payments or to shorten the life of your mortgage? Or are you interested in converting some of your home’s equity into cash?
Answering the questions above might help you determine what’s best for you as you consider refinancing your mortgage. Knowing your financial goals and speaking with an expert mortgage professional could help you assess what your optimal refinance path might be.