A Cash Out Refinance Defined

What is a cash out refinance and why do mortgage interest rates increase for these types of loans?

5 Answers

A cash out can vary depending on the loan type, the lender, and the guidelines that they follow. For our purposes I will cover the most common loan, a conventional Fannie Mae/Freddie Mac mortgage. Most other loan guidelines follow similarly.

The current Fannie/Freddie definition of a cash out mortgage is any new mortgage that includes money to do anything other than pay off an existing first mortgage, and cover the closing costs associated with the loan. Examples would be paying off a first mortgage, a second mortgage, credit cards, any other debt or actually receiving cash back from the close of the loan. If you are just paying off a first mortgage and closing costs, you can typically receive up to 2% of the loan amount up to a maximum of $2000 back before it would be considered cash out. Once you pass either $2000 or 2% of your loan amount your loan application is considered cash out. There is one caveat under the Fannie rule that says that if you are paying off a first and a second mortgage, AND the funds from the second were used to purchase the home, than it can be considered a Rate and Term refinance (non cash out).

The reason interest rates increase on cash out loans is that a cash out loan is typically viewed as a riskier loan than a simple rate and term transaction. Think about it from the lender or Fannie's perspective - if someone owes $150,000 on a home worth $250,000 and simply wants to refinance the $150,000 loan to lower their interest rate, assuming they are able to make their payments, the loan becomes less risky than their current loan. This is because you are not increasing the exposure to default, as the loan amount is the same, and by lowering their interest rate their monthly payment will actually go down. Now look at it as a cash out. Let's say that the same person wants to get a loan for $200,000 on the $250,000 house, paying off the existing $150,000 mortgage and paying off credit cards with the other $50,000. In theory, they will be lowering their payments and consolidating debt, this is good for the borrower as it puts them in a stronger financial position. However, from the lenders perspective, they have now lent $200,000 on the $250,000 house. To the mortgage lender, they now have 80% exposure to the value of the home, versus only 60% if they had completed a rate and term refinance. While it's true that the borrower hasn't incurred any new debt, the lender is in a worse position in regards to collateral than if they had only lent $150,000. To compensate for this higher risk, they impose pricing hits in the form of either higher closing costs, or higher interest rates for the borrower.

A cash out refinance is any loan where the loan amount is greater than the current mortgage being paid off, plus closing costs, plus in some cases 1% of the new loan amount, but no more than $2,000.  Here is an example:

Let's say that the loan amount you are applying for is $150,000.  The current mortgage on the property to be paid off is $100,000 and the closing costs total $4,000.  In this case all you would need to payoff your current mortgage and cover closing costs is $104,000.  That leaves an extra $46,000, which is cash that would go into your pocket.  Since $46,000 is greater than the $2,000 allowable excess funds this is considered a cash out refinance.

The reason mortgage rates increase on cash out refinances and the reason this type of loan has greater loan to value and credit restrictions is because the lenders consider this a riskier type of loan.  The greater the risk the greater return lenders seek.  In most cases the rates are not actually higher on cash out refinances, however there are points associated with these loans.  These point charges can be rather hefty, depending upon the loan to value and the borrower's credit score.  Often times a higher interest rate can be selected to help offset some of these point charges to help minimize the out of pocket expense to the borrower. 

A cash out refinance is a transaction where you borrow more money than you owe on your current mortgage, and keep the cash.  For example, if you own a house that is worth $200,000.00 and you currently have a $100,000.00 mortgage on it, you could refinance it for $150,000.00, using $100,000.00 to satisfy the existing mortgage and "cash out" $50,000.00.

The upside to a cash out refinance is that you get money out of your house, tax free that year.  The downside is that when you sell the house, your profit is figured on the difference between what you paid for the house and how much you sold it for.  How much you owe at the time of the sale has nothing to do with it.  This is one of the problems that people who are currently " upside down" on their mortgages (they owe more on their mortgage than the house is worth) may have.  Assume someone bought property a long time ago, for $50,000.00. During the "boom" years refinanced it for $200,000.00 (getting cash out of about $150,000.00), and now the house is only worth $100,000.00.  They can no longer afford the payments on the mortgage (having spent the $150K on investing in more real estate), and have to "short sell" the property (sell it for less than what is owed on the existing mortgage).  In this example, our seller would get 1099 income from the mortgage company of $100,000.00 (being the difference between what they owed on the mortgage - $200,000.00 and what they were able to sell the house for - $100,000.00).  In addition, they would also have a capital gain of $50,000.00, being the difference between what the house sold for ($100K) and what they paid for the house ($50K)!

A cash-out refinance is any transaction where money is going to be disbursed directly or indirectly to the borrower above and beyond the payoff of the current mortgage and settlement costs. There are several key issues that are not obvious cash-out loans and I'll cover those as well as exceptions. My answer should cover 99% of the loan scenarios out there. I'll always have the disclaimer loan programs change daily and check with your lender for details.

Exceptions:You are allowed to receive up to $2,000 cash-back on a limited(no cash-out) fannie & freddie loans and also up to $500 under VA & FHA rate & term refinance loans.

Scenarios not obvious:If you are paying off a 2nd mortgage not used to purchase the property (such as a home equity loan) even though you are not getting any cash in hand at closing the loan is still considered cash-out under fannie and freddie guidelines.

Scenarios not obvious: If you are paying off other debts, such as credit cards and not receiving any cash in hand at closing the loan is still considered cash-out.

The reason cash-out loans have higher interest rates is risk and equity. Since you're taking cash-out you'll have less equity to secure the loan making it more risky to lend and also if you're taking cash-out of the home you are displaying tendency to use your home as an ATM and might not have the best spending habits.  You also could be cashing out as much as possible before you let the home go back to the bank. Cash-out loans have higher default rates for these reasons and others the cause lenders to increase interest rates to offset losses.

There are credit unions, portfolio lenders and banks that do not sell loans to fannie mae and freddie mac and do not have higher interest rates for cash-out loans. As an industry standard that's not the case.

A 'cash out' refinance is one where you increase your mortgage balance for other than the closing costs incurred for your refinance.  Pricing adjustments, which affect points for obtaining the same rate for a 'non cash out' refinance, have been around for the past 12-18 months.  The perception is that there is much more risk with this type of loan.  Property values could decrease which would affect the equity position of the lender negatively.  The homeowner has fewer options and less wiggle room if the property needs to be sold quickly to satisfy the debt.  The FICO score of the borrowers also play a part in the price.   As does the loan to value.  These adjustments may vary from lender to lender, but the higher the loan to value combined with the cash out nature of the transaction will mean a higher price to the borrower.  A lower credit score [FICO] will mean even a higher price to the borrower.

Because of many of these adjustments, some borrowers may be better off looking at the FHA program, even if MIP must be paid on the loan.  The lower rate may more than compensate.

In short, the greater the risk, the greater the reward.  So a lender is going to want to be rewarded for taking on additional risk.