A cash out refinance is to refinance a mortgage for an amount in excess of the balance owed resulting in a new larger loan to replace the old one.
Cash-out refi is the jargon and short hand used for it by professionals.
The new loan basically consist of 2 portions.
- A home loan equal to the old loan to replace it
- A term loan that is drawn down by the borrower
Together, it amounts to the new loan.
Because from such a transaction, a borrower manages to generate cash in the form of the term loan, thus it is referred to as a “cash out”.
As the term loan resembles that of a typical home equity loan, such a deal is often termed as a cash out or equity loan interchangeably.
This is even when a home equity loan is technically a different event concerning a second mortgage.
For academic and professional purposes, Fannie Mae and Freddie Mac do have a definition to describe non-cash-out loans.
But in layman language, non-cash-out refinancing refer to taking a new mortgage equal to, or less then the existing mortgage, plus loan settlement costs, to replace the existing one.
So by definition, anything else in the refinance arena will be a cash out.
A cash out refinance if often triggered when a homeowner seeks refinancing of his existing mortgage and find the interest rates so attractive that he decides to take on more debt instead of just other outstanding debt.
The second most common reason for it to take place is when a borrower needs to generate funds for personal reasons like to start a new business or for investment purposes.
Accessing the equity locked in the house makes a lot of sense firstly as there is a feeling that the equity in the property is put to good use. Secondly, interest rates on secured loans tend to be much cheaper than those that are unsecured.
Should the main reason for the cash out is to raise cash, then there is every possibility that the homeowner might accept a loan with interest rates higher than the existing mortgage.
This is due to the reason that the priority of the borrower is getting funds instead of financial savings.
Take note that,
- If a cash out refi comes with an interest lower than the existing loan, there is a likelihood that taking on a second mortgage would be more expensive.
- If the cash out refi rate is higher than that of the existing loan, choosing a second mortgage as an alternative could very well be cheaper. This is even though the APR could be well above the the cash out refi rate.
The second point above is due to a second mortgage only takes into account the much smaller term loan, while a refinance concerns the existing loan plus the extra term loan.
For example, if the balance on an existing loan is $100,000 at 8%, and the borrower desires to take on an additional $15,000 cash, the interest on a total amount of $115,000 could be 8.5%, while a smaller loan of only $15,000 for a second mortgage could be 9.5%.
Under this scenarios, when we put interest cost into perspective, while a borrower might pay an additional 1% on $15,000 ($150) with a second loan, he will avoid paying 0.5% more on $100,000 ($500).
It is also important to remember that should a new loan be taken from the same existing lender, then the borrower can avoid a lot of closing costs.
But if it is with a new different lender, then these closing costs have to be paid for one way or another.
Finally, when deciding on a cash out refinance, one should treat it like any other mortgage and apply tips to secure the best deal available.