Last week’s average 30-year fixed-rate mortgage rate dropped 0.04%, to 3.13%. Although rates have not been below 3% since February, they are still very close to all-time historic lows, not to mention being 1% lower than pre-pandemic levels.
This low rate environment, combined with rising home prices, can be especially beneficial for existing homeowners, allowing them to turn their home equity into cash with a cash-out refinance. Nearly half of all refinances in the second quarter of 2021 were cash-out refinances, according to property data analytics firm Black Knight, up from 37% in the first quarter of the year.
But there are some considerations that may make other refinancing options — or not refinancing at all — a better fit for you. Here’s how to calculate whether a cash-out refinance makes more sense for your personal financial situation, as well as some alternatives.
ABOUT THE LATEST MORTGAGE RATES
Last week’s average mortgage rate is based on mortgage rate information provided by national lenders to Bankrate.com, which like NextAdvisor is owned by Red Ventures.
Cash-Out Versus a Rate-and-Term Refinance
A refinance is when you replace your existing mortgage with a new one. A rate-and-term refinance focuses primarily on changing your interest rate and loan term—allowing you to save money by locking in a lower rate or paying off your loan faster. A cash-out refinance means taking out a mortgage loan larger than what you owe and pocketing the difference as cash.
A rate-and-term refinance is best suited for those who are looking to change only the rate and/or length of their mortgage. There are typically fewer closing costs for a rate-and-term refinance. You may still be able to get a small amount of cash out on a rate-and-term refinance through a process known as a limited cash-out refinance. You can get cash up to $2,000 or 2% of the loan amount, whichever is less, according to rules set by Fannie Mae.
A cash-out refinance allows you to get much more cash in your pocket, which you can then use for things like funding home improvements, consolidating high-interest rate debt, or investing. Cash-out refinances are generally more expensive and come with higher closing costs.
The example below shows the hypothetical costs of a rate-and-term refinance and a cash-out refinance for a 30-year loan term with an original loan that was a $270,000 30-year loan at 4.75%.
- Home value: $300,000
- Maximum cash-out refinance amount (up to 80% of home value): $240,000
- Existing loan balance: $200,000
- Cash-out amount : $40,000
- Current monthly payment: $1,408
Using the NextAdvisor mortgage calculator, we can see some of the major differences:
|New Monthly Payment||Interest Rate||New Balance||Total Interest Paid Over 30 years|
|Cash-Out Refinance (30-Year)||$1,111||3.75%||$240,000||$160,277|
|Rate-and-Term Refinance (30-Year)||$843||3%||$200,000||$103,601|
With a rate-and-term refinance, your payments will be lower, you’ll have a lower interest rate, and you’ll pay less in total interest charges over the life of the loan.
A cash-out refinance has the benefit of allowing you to get cash by tapping into your home’s equity. However, you would most likely be paying a higher rate, have greater closing costs, and have a higher monthly payment.
When You Should (and Shouldn’t) Do a Cash-Out Refinance
A cash-out refinance can be a great way to secure financing at a low interest rate — even more so in this current rate environment — but just because you can turn your home equity into quick cash doesn’t mean you should.
A cash-out refinance will reduce the amount of equity you have in your home and increase the time it takes for you to pay off your loan. And, as with any method of home equity financing, the money you borrow is backed by your house as collateral, meaning you could lose your home if you fall behind on payments. Before you consider a cash-out refinance, make sure you have a good use for the cash you’re taking out and a solid plan to pay off the loan.
2 Good Reasons for a Cash-Out:
- To consolidate high-interest debt: With the average 30-year fixed-rate mortgage rate hovering just a hair over 3%, you can use a cash-out refinance to pay off and consolidate other high-interest debt. You’ll get the benefit of simplifying your finances by reducing the number of creditors you have to pay each month.
- Home improvements: If you’re looking to do some renovations, upgrades, or repairs to your home, a cash-out refinance can be a good way to finance those expenses at a lower interest rate compared to credit cards or personal loans. Depending on your tax circumstances, the mortgage interest might be tax deductible. Plus, the upgrades may improve your home’s value.
3 Reasons You Shouldn’t Do a Cash-Out:
- If you plan on moving or selling your house in the near future: Closing costs are almost always involved with a refinance and can range from around 3% to 5% of your loan amount, so you’ll want to make sure that you’ll see enough of a benefit to make it worthwhile. If you plan on moving or selling your home soon, you’re unlikely to break even on the closing costs.
- If you don’t have enough equity to justify the closing costs: Depending on how much equity you have in your home, lenders may have limitations on how much cash you can get. Cash-out refinances are more expensive than a rate-and-term refinance, so you’ll want to make sure you can pull out enough cash to justify the added closing costs.
- To buy a new car: Buying a new car with the proceeds from a cash-out refinance is usually a bad idea because you could end up paying more in total interest charges due to the length of the loan, despite a lower interest rate. For instance, using the NextAdvisor loan calculator, a $20,000 auto loan with a 5% interest rate paid over 5 years will cost $2,645 in total interest. However, that same $20,000 added to a 3% interest rate mortgage paid over 30 years will cost $10,427 in total interest.