What Is a Cash-Out Refinance? Get a Stack of Cash From Your Home Equity
Need a large chunk of change to start a business, pay down debt, or finance your child’s college tuition? If your home value has increased, one option is to use a cash-out refinance. Anything that talks about "cashing out" sure sounds good, right? But before you sign up, let's discuss the cash-out refinance rules—and the real-world pros and cons.
A cash-out refinance is the process of refinancing your mortgage for more than you currently owe and taking the difference in cash. You are in effect “cashing out” some of the equity in your home to pay for something else. Your new loan will be the amount you still owe on your mortgage plus the cash you wanted to take out.
For example, say you had a $300,000 loan, on which you still owed $200,000. That would mean you had $100,000 in equity in your house. Maybe you wanted to pay down some credit card debt, so you cashed out $25,000 of that equity, and got a new mortgage for $225,000, to replace your existing $200,000 loan.
You might be thinking, "Hold on! A cash-out refinance sounds more than a little like a home equity line of credit!" Here’s how it differs: A home equity line of credit, or HELOC, is a second loan on top of your first one, while a cash-out refinance actually replaces your existing mortgage.
So in our scenario above, if you used a cash-out refinance, you would end up with a completely new loan for $225,000. If you got a HELOC, it would keep your $200,000 existing loan and then give you a second loan of $25,000.
Because it’s part of a mortgage, the money you take as cash will typically have a better interest rate than if you were to use a credit card to fund the same purchase. So, for example, if the interest rate on your credit card is 12%, but your mortgage interest rate is only 4%, you can save a bundle getting the cash from a refinance rather than putting the expense on your plastic.
You’ll also benefit from the mortgage tax deduction, adds Cheryll A. LeBlanc, a loan officer at Fairway Independent Mortgage Corporation in Holden, MA.
"I would look at a cash-out refinance if my client needed a lump sum of money, like $25,000 for a remodel that may improve their home value,” says LeBlanc. It’s an especially good option if you are intending to refinance anyway, particularly to take advantage of a lower interest rate.
If you are able to refinance to a lower interest rate, that could make a lot of sense. But if your interest rate was, say, 3.5% and today’s interest rate is 4.5%, you’d be refinancing your mortgage at a higher rate, which would cost you more money over the long run.
“If you already have a great rate on your mortgage, you could end up losing out if you refinance, and rates have risen from where yours was,” LeBlanc cautions.
Plus, you’ll have to pay closing costs, which average about 3% to 6% of your total loan.
Keep in mind that you'll also have to a pay closing cost on a HELOC, but it will only be on the amount of the HELOC. So in a worst-case scenario, 3% of a $25,000 HELOC is $750, whereas 3% of the new cash-out refinance amount of $225,000 is $6,750.
As for interest rates, when you tap a HELOC for $25,000, you are paying the higher interest rate only on the money you’re borrowing—the $25,000—rather than the whole mortgage plus the cash-out refinance of $225,000.
In addition, with a cash-out refinance, you could potentially be setting the clock back when you start a new 30-year loan, which sounds like an awfully long slog if you’ve already paid off a number of years on your mortgage loan.
LeBlanc adds that many financial advisers frown on tapping your home equity for purchases.
“If the reason for borrowing is a transient reason, such as a short business deal or tuition, I might recommend a HELOC that they can pay off and then use again when needed unless they were refinancing for a better rate anyway,” LeBlanc says.
Cash-out refinances are making bank in the industry
If those “cons” are making you think a cash-out refinance is a loser product, you might be interested to know that despite all of these apparent drawbacks, the technique is quite popular. In fact, nearly 42% of refinances in the third quarter of 2016 were cash-out refinances, according to Lynn Fisher, vice president of research and economics for the Mortgage Bankers Association.
Their popularity reflects the rise in equity that many homeowners have enjoyed over the past few years—proving that if they (mortgage lenders) build it, homeowners will come!
For more smart financial news and advice, head over to MarketWatch.
How To Write Cash Out Refinance Letter Of Explanation
Letter of explanation known as LOX or LOE is a common way banks and lending institutes requests to receive financial information from their borrowers and people who are applying for loans and mortgage refinancing. If you are facing a mortgage refinancing, and you plan to do a cash-out refinancing, there are chances you will be asked by your lender to write them a letter of explanation for this cash out refinancing decision.
Letter of explanation is a legal document that institutes need to cover their risk management before underwriting a loan or a new mortgage. When an applicant requests a new home loan or to refinance their current mortgage, the lender needs to see and understand the ‘big-picture’ behind the figures, and numbers.
After the request has been submitted it will be reviewed by a mortgage specialists to see if it is safe to issue and fund the borrower with a new mortgage to replace their existing one. This is part of the risk management the lender must do, in order to make sure the borrower is creditworthiness is safe and sound, and the refinanced mortgage would be paid on time and in full.
There are plenty of financial events when the figures and numbers need further explanation, so the specialists could see the whole picture. Here are examples to general situations when a letter of explanation might be requested:
- Borrowers need to explain new inquiries in the for their credit report, too many inquiries or inquiries in the last 30 days might be because a new loan was requested (car loan for example) and the lenders needs to know that to calculate the debt to income ratio.
- Lenders would request a LOE to explain late mortgage payments, or past due payments that show on FICO credit report.
- Letter of explanation might be needed if there was a period in which the borrower was unemployed. The lender would want to understand how stable is your current job, compared to the former one.
- Letter of explanation are sometimes needed to explain personal events which effect might be seen in the financial figures and credit reports such as divorce, spouse death, illnesses etc.. In times like these, negative items might be recorded to the reports but with a simple explanation, would not stop a lender from providing a refinance mortgage to a person.
When it comes to refinancing there are several topics which the lender needs more explanations in order to evaluate the application and reach a decision whether to approve the refinancing. Cash out refinancing means the borrower refinances the mortgage and requests more funds on that mortgage, which will be given as cash.
For example, a home value of $350,000 and a current mortgage of $250,000, the borrower has home equity of $100,000. When applying for cash out refinancing, the person may take $290,000 mortgage, and be left with $60,000 home equity, and cash out $40,000 for any purpose they want.
Most lenders would like this cash out refinancing to be explained by letter or explanation as they have different ways to evaluate such applications.
Writing Letter Of Explanation For Cash Out Refinancing
The simple rule of thumb is always to be honest and straight forward with your lender. You will be asked to explain by letter the reason you are applying for the cash out refinancing. Here are some guidelines to help you through the writing for this explanation letter (LOX or LOE).
Rule No’ 1 – As mentioned above always tell your lender the true reason why you need the cash out solution, and not applying for a regular refinancing option. If it is a car, or home renovation, let the lender know.
Rule No’ 2 – Remember what you wrote in the mortgage application, be consistent with the initial application. If the cause has been changed, make sure you acknowledge the lender the cause for the cash out, is different from what you wrote in the mortgage application. It is better you write it, than the underwriter finds the causes are not similar..
Rule No’ 3 – If there is one reason lender will not want to see in your letter of explanation for cash out refinance, is that you need the extra cash as down payment for another loan… If it is the reason for your cash out refinancing, see rule no’ 1 – Let your lender know!
Rule No’ 4 – When writing a letter of explanation for cash out refinancing, make sure you have a clear paper trail, to each of the issues you explain in the letter. Writing things down is not enough, add attachments as proof or evidence to your claims. Lack of complete documentation may be one of the reasons an explanation letter is requested in the first place.
Rule No’ 5 – Think WHY the lender asks for the letter of explanation. Once you can foresee what was it that disturbed the lender so much that they requested such letter, you need to write the letter covering the issue and explaining the facts that will fit into the lender’s puzzle. If you are not sure what EXACTLY needs to be explained or WHY the letter was requested, contact the lender, ask them. Once you know what is it they are seeking, you can write explanations more convincing.
Rule No’ 6 – Be professional not an amateur. The person reading the letter of explanation does not wish to read your family history, and all your personal problems. Skip the effort to squeeze some sympathy, explain your self clearly and stick to the facts and build up credibility. Remember every thing you write might be checked and cross checked by the lender, be accurate on what you write.
Since cash out refinancing worries the lender more than regular refinancing, as most lenders what to know their money is going for a good cause and not gambling for example… Make sure you can explain by a letter your needs and plans for the funds you are expecting to cash out from the home equity.
Write a short letter of explanation, stick to the facts, add proof and evidence to your arguments, back the letter with documentation from reliable sources, bank reports, credit statements, legal papers and such. Your letter of explanation can be a single sheet letter or a small file including all that is needed to explained.
If you will do nothing.. don’t expect anything to happen. You must bump your credit score up! It will give you better leverage when facing the lenders, and better negotiation position when applying for any financial need.
Lets not forget you are probably paying $500-$1000 extra per year in higher interest rates, and credit payments.
Yes, you might need to invest a small sum to get a grip of things.. But if you think education is expensive.. try ignorance..
You are probably paying thousands of dollars per year in fees and interests to credit companies which could be going straight to your pocket. Don’t be cheap when it comes to financial education.. Ignorance costs more.